The Tax Court has ruled that parts of the substantial bonuses
paid to the two shareholder/employees of a Minnesota construction company were
not reasonable compensation for services actually rendered and were not deductible
from the corporation's income as ordinary and necessary business expenses (Wagner
Construction, Inc., v. Commissioner of Internal Revenue, TC Memo 2001-160
(6/29/2001)).
The court said that the nondeductible portion was disguised dividends,
but the court ruled partially against the IRS and said that a part of the bonuses
paid to the two executives was reasonable compensation and could be deducted.
Background. Dennis and Curtis Wagner were the sole shareholders
and the executive employees of Wagner Con-struction, Inc. Dennis owned 75 percent
of the stock and Curtis the remaining 25 percent. Both were very experienced
in the company's construction and logging businesses and worked long hours.
Between 1985 and 1996, the corporation's annual sales grew from $2 million to
$6 million. The corporation never paid dividends, and profits were often put
back into the company.
In 1995 and 1996, Dennis and Curtis were each paid an annual
salary of close to $50,000, but Dennis was also paid a bonus of $1 million in
1995 and $650,000 in 1996. Curtis was paid a $200,000 bonus in 1995 and $350,00
in 1996. IRS disallowed most of the deduction from the corporation's income
for the 1995 and 1996 bonuses. Wagner Construction claimed the full amount was
reasonable compensation. When the case reached the Tax Court, IRS had conceded
that bonuses equal to approximately $200,000 and $250,000 paid to Dennis in
1995 and 1996 and $150,000 paid to Curtis in each year were reasonable compensation.
Ruling. Both parties in this case presented expert witnesses
to support their position of what was reasonable compensation. The judge, however,
found that the arguments of all the experts were riddled with factual and logical
holes and angrily rejected their opinions stating that the experts "reached
conclusions that patently favored their respective clients, and their reports
were designed to support their conclusions."
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The Law
A corporate employer
may deduct from its taxable income payments for reasonable compensation
for services actually rendered (IRC Sec.162(a)(1)). Whether compensation
is reasonable is a question of fact that must be answered by comparing
an employee's compensation with the value of services that he or she
performs. In the case of employees who also control the corporation
(such as majority shareholders), there is a lack of arm's-length bargaining,
and special scrutiny must be given to bonus payments, because such payments
"may be distributions of earnings rather than payments of compensation
for services rendered; even if they are reasonable, they would not be
deductible" (Charles Schneider & Co. v. Commissioner, 500 F.2d 148,
CA-8 (1974)).
In the Schneider
case, the U.S. Court of Appeals for the 8th Circuit listed the following
factors courts consider in assessing the reasonableness of an employee's
compensation:
(1) The employee's
qualifications;
(2) The nature,
extent, and scope of the employee's work;
(3) The size and
complexities of the business;
(4) The prevailing
general economic conditions;
(5) The prevailing
rates of compensation for comparable positions in comparable concerns;
(6) The salary policy
of the taxpayer as to all employees;
(7) In the case
of small corporations with a limited number of officers the amount of
compensation
paid to the particular employee in previous years;
(8) A comparison
of salaries paid with the gross income and the net income; and
(9) Comparison of
salaries with distributions to stockholders.
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The court made its own analysis of what was reasonable compensation in this
case. The brothers' qualifications; the nature, extent, and scope of their
work; and the complexity of the business all supported paying them high compensation
well above their base salary, said the court. The fact that the corporation's
sales increase from $4 million to $6 million during the two years at issue,
which could not have resulted from changes in general economic conditions
and must have resulted from the hard work and expertise of Dennis and Curtis,
would also justify high compensation. Based on the data supplied by the experts
that the court found reliable, the court determined that comparable companies
were paying at least $385,00 per year for a chief executive officer such as
Dennis and $250,000 per year for a chief operating officer such as Curtis.
Wagner Construction paid their other employees the highest salaries
under the union contract. The brothers' base salary was far below that paid
to executives of other companies. These factors supported a finding that part
of the bonuses was compensation for services. But none of the other employees
received bonuses. The fact that the bonus policy for shareholder employees was
different than that for nonshareholder employees was an indication that the
bonus was in part a distribution of profits. The court also determined that
any under compensation in earlier years was fully rectified before 1995. These
facts also supported a conclusion that the bonuses were partially a distribution
of profits.
The court then compared the bonuses to the corporation's gross
and net income in each year. While the corporation had substantial gross income,
its net in 1995 was a loss of $13,944 and in 1996 net income was $243,000. The
court found that the ratio of compensation paid to these figures supported the
IRS position in 1995 and was neutral in 1996. Finally, the court noted the absence
of dividends ever being paid.
The court then went on to carefully scrutinize the facts because
Dennis and Curtis controlled Wagner Construction to determine if the bonuses,
even if reasonable in size, were intended as distributions of corporate earnings.
These factors included that the bonuses were in proportion to the brothers'
shareholdings, that the payments were in lump sums rather than as the services
were rendered, that there was an absence of a formal dividend distribution by
the growing corporation, that the bonus system was unstructured with no relationship
to services rendered, and that the company had negligible taxable income for
four straight years, indicating that the bonus size was based on funds available
rather than services rendered.
The court balanced all of the factors and decided that bonuses
of about $315,000 paid to Dennis in each year and $200,000 paid to Curtis were
compensation for services rendered and could be deducted.