I read the
tax literature differently than I did early in my career. There is certainly more
of “been there, read that,” but there is also more consideration of why the IRS
decided to pursue an issue.
I am
convinced that sometimes the IRS just walks in face-first, as there is no
upside for them. Our recent blog about the college student and her education
credit was an example. Other times I can see them backfilling an area of tax
law, perhaps signaling future scrutiny. I believe that is what the IRS is doing
with IRAs-owning-businesses (ROBS).
A third
category is when the IRS goes after an issue even though the field has been
tilled for many years. They are signaling that they are still paying attention.
I am looking
at a reasonable compensation case. I believe
it is type (3), although it sure looks a lot like type (1).
To set up
the issue, a company deducts someone’s compensation – a sizeable bonus, for
example. In almost all cases, that someone is going to be an owner of the
company or a relation thereto.
There are
two primary reasons the IRS goes after reasonable compensation:
(1) If the taxpayer is a C corporation (meaning it
pays its own tax), the deduction means that the compensation is being taxed
only once (deducted by the corporation; taxed once to the recipient). The IRS
wants to tax it twice. In a C environment, the IRS will argue that you are
paying too much compensation. It wants to move that bonus to dividends paid, as
there is no tax deduction for paying dividends.
(2) If the taxpayer is an S corporation (and
its one level of tax), the IRS will argue that you are paying too little compensation.
There is no income tax here for the IRS to chase. What it is chasing instead is
social security tax. And penalties. Some of the worst penalties in the tax Code
revolve around payroll.
There is a
world of literature on how to determine “reasonable.” The common judicial tests
have you run a gauntlet of five factors:
(1) The employee’s role in the company
(2) Comparison to compensation paid
others for similar services
(3) Character and condition of the
company
(4) Potential conflict of interest
(5) Internal consistency of compensation
Let’s look
at the Johnson case as an example.
Mom and dad
started a concrete company way back when. They had two sons, each of which came
into the business. They specialized in Arizona residential development. As time
went on, the brothers wound up owning 49% of the stock; mom owned the
remainder. The family was there at the right time to ride the Phoenix housing
boom, and the company prospered.
A downside
to the boom was periodic concrete shortages. The company did not produce its
own concrete, and the brothers came to believe it to be a business necessity.
They presented an investment opportunity in a concrete supplier to mom. Mom
wanted nothing to do with it; she argued that the company was a contractor, not
a supplier. This was how companies overextend and eventually fail, she
reasoned.
The brothers
went ahead and did it on their own. They invested personally, and mom stayed
out. They even guaranteed some of the supplier’s bank debt.
Who would
have thought that concrete had so many problems? For example, did you know that
concrete becomes unusable after
(1) 90 minutes or
(2) If it reaches 90 degrees.
I am not
sure what to do with that second issue when you are in Phoenix.
The brothers
figured out how to do it. They developed a reputation for specialized work.
They worked 10 or 12 hours a day, managed divisions of 100 employees each, were
hands-on in the field and often ran job equipment themselves. Sometimes they even
designed equipment for a given job, having their fabrication foreman put it
together.
Not
surprisingly, the developers and contractors loved them.
That
concrete supplier decision paid off. They always had concrete when others would
not. They could even charge themselves a “friendly” price now and then.
We get to
tax years June 30, 2003 and 2004 and they paid themselves a nice bonus. The
brothers pulled over $4 million in 2003 and over $7 million in 2004.
COMMENT: I really missed the boat back in college.
The brothers
were well-advised. They maintained a cumulative bonus pool utilizing a
long-time profit-sharing formula, and they had the company pay annual dividends.
The IRS
disallowed a lot of the bonus. You know why: they were a C corporation and the
government was smelling money.
The Court
went through the five tests:
(1) The brothers ran the show and were
instrumental in the business success. Give this one to the taxpayer.
(2) The IRS argued that compensation was
above the average for the industry. Taxpayer responded that they were more
profitable than the industry average. Each side had a point. Having nothing
more to go on, however, the Court considered this one a push.
(3) Company sales and profitability were
on a multi-year uptrend. This one went to the taxpayer.
(4) The IRS appears to have wagered all
on this test. It brought in an expert who testified that an “independent
investor” would not have paid so much compensation and bonus, because the
result was to drop the company’s profitability below average.
Oh, oh. This was a good argument.
The idea is that someone – say Warren Buffett – wants to buy
the company but not work there. That investor’s return would be limited to
dividends and any increase in the stock price. Enough profitability has to be
left in the company to make Warren happy.
This usually becomes a statistical fight between opposing
experts.
It did here.
And the Court thought that the brothers’ expert did a better
job than the government’s expert.
COMMENT: One can tell that the Court liked the brothers. It
was not overly concerned that one or two years’ profitability was mildly compromised,
especially when the company had been successful for a long time. The Court decided
there was enough profitability over enough years that an independent investor
would seriously consider the company.
Give this one to the taxpayer.
(5) The company had a cumulative bonus
program going back years and years. The formula did not change.
This one went to the taxpayers.
By my count
the IRS won zero of the tests.
Why then did
the IRS even pursue this?
They pursued
it because for years they have been emphasizing test (4) – conflict of interest
and its “independent investor.” They have had significant wins with it, too, although
some wins came from taxpayers reaching too far. I have seen taxpayers draining
all profit from the company, for example, or changing the bonus formula whimsically.
There was one case where the taxpayer took so much money out of the company
that he could not even cash the bonus check. That is silly stuff and low-hanging
fruit for the IRS.
This time
the IRS ran into someone who was on top of their game.
