Let’s say
that you own 100% of a company. Let’s say your company is quite profitable, and
that you take out massive bonuses at year-end. The bonuses serve two purposes:
first: why not? You took risk, borrowed money and worked hard. If the thing
folded, you would have sunk with it. If it succeeds, why shouldn’t you succeed
with it? After all, no politician built it for you. Second, bonuses help reduce
taxes the company has to pay. Granted, they increase the taxes the shareholder
has to pay, but that is a conversation for another day.
Let’s say
the IRS questions the bonus. They think
your bonus is unreasonable.
Let’s discuss
the Midwest Eye Center case.
Dr. Afzal
Ahmad was the sole shareholder of Midwest Eye Center (Midwest), a multi-location
ophthalmology and eye care center in Chicagoland. This is a pretty large practice,
with approximately 50 employees, five surgeons, three optometrists and so on.
Dr. Ahmad was doing well, receiving a salary of $30,000 every two weeks. At the
end of the year he would also draw a sizeable bonus, which coincidently reduced
corporate taxable income to zero. In 2007 he took a bonus of $2,000,000.
Dr. Afzal Ahmad |
There were
reasons for the bonus. One of his busier surgeons quit unexpectedly in June,
2007. That surgeon was generating approximately $750,000 in revenues, and Dr.
Ahmad took over the additional patients. Then there was another doctor who was reducing
her workload as she established her own practice. Dr Ahmad starting absorbing
some of these patients too.
Busy year
for the doctor.
One more
fact: Midwest filed taxes as a C corporation, which means it paid its own
taxes.
The IRS came
in and disallowed $1,000,000 of the bonus. Why $1,000,000 exactly? Who knows,
except that (1) it is an impressive amount, and (2) it is close enough for
government work.
As Midwest was
a professional services corporation, its tax rate was the maximum, so there
immediately was additional tax of $340,000.
The IRS also assessed penalties of over $62,000.
This was a
nice audit for the IRS: limited issues and big bucks.
So how did
the tax advisor defend Midwest?
There is standard
text that any tax practitioner (at least, one who follows tax cases) has read a
thousand times:
“Deductions are a matter of legislative grace and are allowed
only as specifically provided by statute.”
Basically
the tax Code says that everything is taxable and nothing is deductible – unless
the Code says otherwise. IRC Section 162
allows us to deduct “reasonable and necessary expenses.” So far, so good.
Salaries have to be deductible, right? Hold up. The Code says that a
“reasonable allowance for salaries or other compensation” is deductible.
We have to
show the “reasonableness” of the salary.
The first way
is to show that an “independent investor” would have paid the salary. Midwest
decided not to use this line of defense, as no dividends were paid and no
profits were left in the company. You have to leave some crumbs on the plate so
the investor does not starve. Granted, Warren Buffett does not pay dividends,
but he always leaves profit in Berkshire Hathaway.
OBSERVATION: The lack of dividends does not have to be fatal,
but it does complicate the argument. For example, if I owned an NFL team, I
might be willing to operate it at a loss. The value of my team (if I were to
sell it) would likely be increasing more than enough to offset that operating
loss.
The next way
is by comparison to other businesses. Think professional athletes. If a team is
willing to pay the salary, the player must then be worth it. Therefore if
someone somewhere with your job duties has a similar salary, there is a prima facie
argument that your salary is reasonable. This is more difficult to do with
closely-helds than publicly-tradeds, as closely-helds do not tend to publish
profitability data.
A third way
involves profit-sharing and other incentive plans, hopefully written down and providing
formulas should certain thresholds be met. It is important to establish the
plan ahead of time and to be certain there is some rhyme or reason to the
calculations. Examples include:
- Documenting the doctor’s activities over the years, putting a value to it and keeping a running tally of how compensation is still due. This can be done to “reimburse” the shareholder for those start-up years when the money was not there to properly compensate the shareholder, for example.
- Setting up a bonus formula and following it from year-to-year. If there isn’t enough cash to pay out the amount generated by the formula, then the business would accrue it as “compensation payable.” It is not deductible until paid, but it does indicate that there is a compensation plan in place.
- Having an independent Board of Directors, who in turn decide the amount of compensation. This can be done on an annual basis, preferably earlier rather than later in the year. This technique is not often seen in practice.
- Valuing the company on a regular basis (perhaps as frequently as annually). The intent is to attribute the increase in the value of the business to the shareholder’s efforts. The business would then share some of that increase via a bonus.
So what did
Midwest do?
They did
nothing, that’s what they did.
And I am at
a loss. Midwest had a professional tax preparer, but when push came to shove
the preparer provided the Court … nothing.
On to the
penalty. The IRS will reverse a penalty if the taxpayer can show that he/she
relied upon professional advice. The insurance companies go apoplectic, but it
is common (enough) practice for a CPA to fall on the sword to get the client
out of a penalty.
But
Midwest’s tax preparer was nowhere to be found.
The IRS won
on all fronts.
My thoughts?
My corporate
clients have overwhelmingly shifted to S corporations over the years. S corporations
have their own tax issues, but reasonable compensation is not one of them. It
is rare for a tax practitioner to recommend a C corporation nowadays, unless
that practitioner works with Fortune 500 companies.
Midwest is
an example why. It is a second pocketbook for the IRS to pick.