The Tax Court Case
A business owner had been President, CEO, and COO of a company since 1972, controlling all aspects of the company's operations. For 2002 and 2003 (the years at issue), the business claimed a deduction of over $2 million each year (salary and bonuses) for the owner's compensation. The IRS thought this compensation was unreasonable.The petitioner (the taxpayer) has the burden of proving that the payments were reasonable.
Determining "Reasonable Compensation"
The Court used several previous decisions, primarily a 9th Circuit Court appeals case (Elliotts, Inc. v. Commissioner, 9th Cir., 1983) in setting out the factors to be used. Here are the factors and how the Court used them in this case:
1. The employee's role in the company. Since the owner was in full charge of all operations, this factor weighed heavily in the company's favor.
2. Comparison with other companies. Expert testimony was presented by both sides, but the Court didn't find either side's experts convincing, persuasive, or reliable.
3. The character and condition of the company. Although revenues fluctuated year to year, the Court found that the company was "one of the most successful companies of its kind," which weighed in the company's favor.
4. Potential conflicts of interest. The Court uses a hypothetical "independent investor" test for this factor. In other words, would an investor be happy about the compensation paid to this executive, given the company's return on equity for the year in question and the executive's performance? In the Elliotts case mentioned above, the Court found that a 20% average return on equity would satisfy an investor. Although the return fluctuated somewhat during the years at issue, the Tax Court said that the company's stability and growth was solely due to the owner and that this factor favored the company's position.
5. Internal consistency in compensation. The Tax Court also found that bonuses and compensation were consistent with company practice over the years.
The Court concluded that the $2 million compensation was reasonable for 2002, but not for 2003, because the company's sales dropped in 2003. Still the Court said that a salary of $1.3 million was reasonable for 2003.
Source: T.C. Memo 2010-139
