You probably assume as the owner of a construction firm that your compensation is nobody’s business but yours. However, since salaries and bonuses are deductible by the corporation, the IRS has an interest in the size of your annual compensation. And, if the service considers your compensation to be “unreasonable,” it may seek to reclassify the excess payment as a dividend. That’s not the best outcome, since dividends are generally nondeductible by the corporation and taxable to the recipient.
This process played out in a recent Tax Court* case addressing the reasonableness of the compensation paid by a family-owned concrete contracting company to two brothers, who were also officers and substantial shareholders. Together, they received total compensation (including bonuses) of $4,025,039 in 2003 and $7,300,916 in 2004. In addition to deducting these payments, the company deducted a $500,000 administration fee paid to a related company to ensure a reliable supply of concrete.
The IRS Says “No”
The IRS argued both that the compensation was “unreasonable” and that the $500,000 administration fee was not an “ordinary and necessary” business expense. The IRS therefore issued a notice of deficiency of $877,440 and $2,087,678 for 2003 and 2004, respectively. The company disputed the IRS’s notice of deficiency, and the case ended up in Tax Court.
The Tax Court applied a multifactor test to determine whether the compensation was “reasonable.” The court considered:
- the employees’ roles in the company
- the compensation paid by similar companies for similar services
- the character and condition of the company
- potential conflicts of interest – specifically, whether a hypothetical independent investor would
- receive a reasonable return on equity after payment of the compensation
- the internal consistency of the compensation arrangement
The Court’s Findings
The court ruled that the compensation paid to the brothers was reasonable. It noted that the brothers were integral to the company’s growth in revenues, assets, and gross profit margins leading up to and including 2003 and 2004. The return on equity that the corporation generated for each year after payment of the brothers’ compensation was in line with and closely approximated the return generated by the companies most comparable to it and therefore would have satisfied an independent investor. Additionally, the court found that the corporation consistently adhered to its officer bonus formula from its inception in 1991.
The court ruled also that the $500,000 payment was an “ordinary and necessary” expense. It noted that it was normal and necessary for a concrete contractor to spend money to ensure a reliable supply of concrete at favorable prices during times of shortage.
* H.W. Johnson, Inc. v. Comm’r, T.C. Memo 2016-95
