SBA Paycheck Protection Program

The last couple of weeks here at Command Center have been … unprecedented.

We have sent employees home, although we have not let anyone go.

Critical personnel (including me somehow) are still coming in, although we are instituting a policy of one-person-in-the-office-at-a-time.  

I understand working at home, but a typical accounting firm is not geared to work from home indefinitely. For one thing, it takes administrative staff to keep the information and document flow going to the at-homers, and there is no administrative staff.

Fortunately, the IRS and many (if not most) states have acknowledged the reality of the situation and are allowing extensions of time to file and pay. There was probably no choice: preparers were not going to be able to get the work done anyway. It is likely that your return will be extended this year, even if you have never extended before.

Some of our clients have shut down. One, for example, works with product promotion at Kroger’s. Have you been to a Kroger’s recently? The last problem they have is moving merchandise.

Let’s talk about something. There is a brand-new SBA program for emergency funding. It may be that you have never considered government assistance before, but these are extreme times.

We are talking about the “Paycheck Protection Program.” Congress took an existing SBA loan program and sweetened the pot. Its purpose is – flat out – to encourage employers to retain employees and – if the employer has already furloughed employees -to hire them back.

Here are the general features of the program:

(1)  It expires June 30, 2020.

(2)  Think businesses with less 500 employees, but there are exceptions.

(3)  In a bit of a surprise for the SBA, the program includes nonprofits (again, with less than 500 employees)

(4)  The maximum loan amount is 2.5 times average payroll during the one-year period before the date the loan is made.

a.    With adjustments for new businesses, of course.

(5)  That maximum caps out at $10 million.

(6)  The loan is principally to fund payroll (with some limitations), but it will also cover health insurance, rent, utilities and some interest expense.

(7)  Now think math:

A times B

A is the sum of those expenses described in (6) for the 8 weeks after you get the loan.

(8)  Let’s talk B.

B is a fraction. The government wants to know whether your workforce has gone up or down in number.

The numerator is going to be the number of employees between February 15 and June 30, 2020.

The denominator is the number of employees during the same period in 2019.

There are adjustments for real-life situations that do not fit the above periods.

There is also a test which substitutes payroll dollars for the number of employees. You fail the test if your payroll reduction (dollar-wise) exceeds 25%.

(9)  So what, you ask.

Let’s say you have 17 employees for the 2020 period.

Let’s say you had 16 employees for the 2019 period.

Fraction-wise, that is over 100%. Let’s round that down to 100%.

Let’s multiply that 100% by something.

What is the something?

The loan you took out.

Let’s say the loan was $125,000.

Multiply $125,000 by 100%.

You get $125,000.

The government will forgive 100 PERCENT of the loan! The entire $125,000 is gone, forgiven, paid-off, hasta luego, soyonara.

Wow.

(10)      Is there a follow-up to that?

Yep.

Generally, the forgiveness of debt results in income to the person whose debt was forgiven. It is why people get those 1099s in the mail from the credit card companies which have given up on collecting.

For purposes of this loan, the forgiveness will NOT count as income.

So let’s get this straight. You keep your employees on board. The government loans you money for your payroll. The government forgives the money. You walk away scot-free.

What happens if you don’t get to 100%? Then a portion of the loan remains. You pay interest not to exceed 4% and repay that portion of the loan over a period of up to 10 years. Still … not bad.

Folks, if this is you – please check it out before the deadline or the funding runs out.

Family First Coronavirus Response Act

Congress passed and the President signed a coronavirus-related bill this week. While mainly addressing employment benefits, it also includes payroll-tax-related provisions to mitigate the effect of the benefit expansion on employers.

Following is a recap of the Act. It is intended as an introduction and quick reference only. Please review the Act itself for detailed questions.

The Family First Corona Virus Response Act has two key employment-benefit components. Employers are to be reimbursed for the benefit expansion via a tax credit mechanism.

A. The Emergency Paid Sick Leave Act

1.  Private employers employing less than 500 employees shall provide an employee with paid sick time if:

i. The employee is subject to quarantine or isolation due to COVID-19.

ii.  The employee has been advised by a health care provider to self-quarantine due to concerns related to COVID– 19.

iii.  The employee is experiencing symptoms of COVID– 19 and seeking a medical diagnosis.

iv. The employee is caring for an individual described in (i) or has been advised as described in (ii).

v. The employee is caring for a son or daughter of such employee if the school or place of care of the son or daughter has been closed, or the child care provider of such son or daughter is unavailable, due to COVID–19 precautions.

vi. The employee is experiencing any other substantially similar condition specified by the Secretary of Health and Human Services in consultation with the Secretary of the Treasury and the Secretary of Labor.

2. Full-time employees are entitled to 80 hours of paid sick time.

3. Part-time employees are entitled to the average number of hours worked on over a 2-week period.  For employees with varying schedules, the employer shall use the employee’s average number of hours per day over the 6-month period ending on the date the employee takes leave under the Act.

4. If an employee takes time off for self-care, the employee shall be compensated at the employee’s regular pay rate.

     i. Not to exceed $511 per day and $5,110 in the aggregate

5. If an employee takes time off for a sick family member or child, the employee shall be compensated at 2/3 of the employee’s regular pay rate.

     i. Not to exceed $200 per day and $2,000 in the aggregate

6. There are comparable provisions for the self-employed.

7. The Act expires on December 31, 2020.

8. The Labor Secretary is authorized to exempt employers with less than 50 employees if the requirements would imperil the viability of the business.

9. Employers who violate this Act shall be considered to have failed to pay minimum wages in violation of the FLSA and be subject to penalties related to such a violation.

B. Emergency Family and Medical Leave Expansion Act (E-FMLA)

1. The Act expands coverage of the Family and Medical Leave Act (“FMLA”) for employers with fewer than 500 employees. Employees are typically not eligible for FMLA leave until they have worked at least 12 months and 1250 hours. 

i.  For purposes of E-FMLA, this threshold is reduced to 30 days.

2.  E-FMLA applies if the employee leave is to care for a child under 18 if the school or place of care has been closed or child care provider is unavailable due to a public health emergency.

3. Protected leave can be for up to 12 weeks, but the first 10 days may consist of unpaid leave.

4.  The employee shall be compensated not less than two-thirds of the employee’s regular rate of pay.

i. Not to exceed $200 per day and $10,000 in the aggregate (for each employee)  

5. There are comparable provisions for the self-employed.

6. The Act expires on December 31, 2020.

7. The Labor Secretary is authorized to exempt employers with less than 50 employees if the requirements would imperil the viability of the business.

8. Employers who violate this Act shall be considered to have failed to pay minimum wages in violation of the FLSA and be subject to penalties related to such a violation.

C. Tax Credits

1. The compensation paid under the Act is not subject to the Old-Age, Survivors and Disability portion of FICA (that is, the 6.2%).

2. The compensation paid under the Act is subject to the Hospital Insurance portion of FICA (that is, the 1.45%).

3. On a quarterly basis, employers can claim a payroll tax credit for the sum of the following:

                a. Wages paid under this Act

b. Allocable “qualified health plan expenses” 

      ... think health insurance

c. The employer portion of Hospital Insurance (that is, the 1.45%)

4. Treasury is authorized to issue Regulations waiving penalties for not making payroll tax deposits in anticipation of the credit to be allowed.

5. The credit is refundable if it exceeds the amount the employer owes in payroll tax.

6. Employer taxable income is to be increased by the amount of payroll credit received.

           i. Otherwise there would be a double tax benefit.    

Trust Fund Penalty When Your Boss Is The U.S. Government

You may be aware that bad things can happen if an employer fails to remit payroll taxes withheld from employees’ paychecks. There are generally three federal payroll taxes involved when discussing payroll and withholding:

(1)  Federal income taxes withheld

(2)  FICA taxes withheld

(3)  Employer’s share of FICA taxes

The first two are considered “trust fund” taxes. They are paid by the employee, and the employer is merely acting as agent in their eventual remittance to the IRS. The third is the employer’s own money, so it is not considered “trust fund.”

Let’s say that the employer is having a temporary (hopefully) cash crunch. It can be tempting to borrow these monies for more urgent needs, like meeting next week’s payroll (sans the taxes), paying rent and keeping the lights on.  Hopefully the company can catch-up before too long and that any damage is minimal.

I get it.

The IRS does not.

There is an excellent reason: the trust fund money does not belong to the employer. It is the employees’ money.  The IRS considers it theft.

Triggering one the biggest penalties in the Code: the trust fund penalty.

We have in the past referred to it as the “big boy” penalty, and you want nothing to do with it. It brings two nasty traits:

(1)  The rate is 100%. Yep, the penalty is equal to the trust fund taxes themselves.

(2)  The IRS can go after whoever is responsible, jointly or severally.

Let’s expand on the second point. Let’s say that there are three people at the company who can sign checks and decide who gets paid. The IRS will – as a generalization – consider all three responsible persons for purposes of the penalty. The IRS can go after one, two, or all three. Whoever they go after can be held responsible for all of the trust fund taxes – 100% - not just their 1/3 share. The IRS wants its money, and the person who just ponied 100% is going to have to separately sue the other two for their share. The IRS does not care about that part of the story.

How do you defend against this penalty?

It is tough if you have check-signing authority and can prioritize who gets paid. The IRS will want to know why you did not prioritize them, and there are very few acceptable responses to that question.

Let’s take a look at the Myers case.

Steven Myers was the CFO and co-president of two companies. The two were in turn owned by another company which was licensed by the Small Business Administration as a Small Business Investment Company (SBIC).  The downside to this structure is that the SBA can place the SBIC into receivership (think bankruptcy). The SBA did just that.

In 2009 the two companies Myers worked for failed to remit payroll taxes.

Oh oh.

However, it was an SBA representative – remember, the SBA is running the parent company – who told Myers to prioritize vendors other than the IRS.

Meyers did so.

And the IRS slapped him with the big boy penalty.

QUESTION: Do you think Myers has an escape, especially since he was following the orders of the SBA?

At first it seems that there is an argument, since it wasn’t just any boss who was telling him not to pay. It was a government agency.

However, precedence is a mile long where the Court has slapped down the my-boss-told-me-not-to-pay argument. Could there be a different answer when the boss is the government itself?

The Court did not take long in reaching its decision:

So, the narrow question before us is whether …. applies with equal force when a government agency receiver tells a taxpayer not to pay trust fund taxes. We hold that it does. We cannot apply different substantive law simply because the receiver in this case was the SBA."

Myers owed the penalty.

What do you do if you are in this position?

One possibility is to terminate your check-signing authority and relinquish decision-making authority over who gets paid.

And if you cannot?

You have to quit.

I am not being flippant. You really have to quit. Unless you are making crazy money, you are not making enough to take on the big-boy penalty.

No Soup For You!

“No soup for you!”

The reference of course is to the soup Nazi in the Seinfield television series. His name is Al Yegeneh. You can still buy his soup should you find yourself in New York or New Jersey.

However, it is not Al who we are interested in.

We instead are interested in Robert Bertrand, the CEO of Soupman, Inc, a company that licenses Al’s likeness and recipes. Think franchise and you are on the right track.

Bertrand however has drawn the ire of the IRS. He has been charged with disbursing approximately $3 million of unreported payroll, in the form of cash and stock.

The IRS says that $3 million of payroll is about $600,000 of unpaid federal payroll taxes.    

Payroll taxes – as we have discussed before – have some of the nastiest penalties going.

And that is just for paying the taxes late.

Do not pay the taxes – as Bertrand is charged – and the problem only escalates. He faces up to five years in prison. His daughter co-signed a $50,000 bond so he could get out of jail.

BTW the judge also ordered him to hire an attorney.

COMMENT: I don’t get it either. One of the first things I would have done was to hire a tax attorney.

I have not been able to discover which flavor of stock-as-compensation Soupman, Inc used, although I have a guess.

My guess is that Soupman Inc used nonqualified stock options.

COMMENT: There are multiple ways to incorporate stock into a compensation package. Nonqualified options (“nonquals” or “NSO’s”) are one, but qualified stock options (“ISO’s”) or restricted stock awards (“RSA’s”) are also available. Today we are talking only about nonquals.

Using nonquals, Soupman Inc would not grant stock immediately. The options would have a delay – such as requiring one to work there for a certain number of years before being able to exercise the option. Then there is the matter of price: will the option exercise for stock value at the time (not much of an incentive, if you ask me) or at some reduced price (zero, for example, would be a great incentive).

Let’s use some numbers to understand how nonquals work.

• Let’s start with a great key employee that we are very interested in retaining. We will call him Steve.
• Let’s grant Steve nonqualified options for 50,000 shares. Steve can buy stock at $10/share. As the stock is presently selling at $20/share, this is a good deal for Steve.
• But Steve cannot buy the stock right now. No, no, he has to wait at least 4 years, then he has six years after that to exercise. He can exercise once a year, after which he has to wait until next year. He can exercise as much of the stock as he likes, up to the 50,000-share maximum.
• There is a serious tax trap in here that we need to avoid, and it has to do with Steve having unfettered discretion over the option. For example, we cannot allow Steve to borrow against the option or allow him to sell the option to another person. The IRS could then argue that Steve is so close to actually having cash that he is taxable – right now. That would be bad.

Let’s fast forward six years and Steve exercises the option in full. The stock is worth $110 per share.

Steve has federal income tax withholding.

Steve has FICA withholding.

Steve has state tax withholding.

Where is the cash coming from for all this withholding?

The easiest solution is if Steve is still getting a regular paycheck. The employer would dip into that paycheck to take out all the withholdings on the option exercise.

OBSERVATION: Another way would be for Steve to sell enough stock to cover his withholdings. The nerd term for this is “cashless.”

It may be that the withholdings are so large they would swamp Steve’s regular paycheck. Maybe Steve writes a check to cover the withholdings.

COMMENT: If I know Steve, he is retiring when the checks clear.

Steve has income. It will show up on his W-2. He will include that option exercise (via his W-2) on his tax return for the year. The government got its vig.

How about the employer?

Steve’s employer has a tax deduction equal to the income included on Steve’s W-2.

The employer also has employer payroll taxes, such as:

·      Employer FICA

·      Federal unemployment

·      State unemployment

Let’s be honest, the employer payroll taxes are a drop in the bucket compared to Steve’s income from exercising the option.

Why would Steve’s employer do this?

There are two reasons. One is obvious; the second perhaps not as much.

One reason is that the employer wants to hold onto Steve. The stock option serves as a handcuff. There is enough there to entice Steve to stay, at least for a few years.

The second is that the employer manufactured a tax deduction almost out of thin air.

Huh?

How many shares did Steve exercise?

50,000.

What was the bargain element in the option exercise?

$110 - $10 = $100. Times 50,000 shares is $5,000,000 to Steve.

How much cash did the employer part with to pay Steve?

Whatever the employer FICA, federal and state unemployment taxes are – undoubtedly a lot less than $5,000,000.

Tax loophole! How Congress allow this? Unfair! Canadian football!

I disagree.

Why?

To my way of thinking, Steve is paying taxes on $5,000,000, so it is only fair that his employer gets to deduct the same $5,000,000. To argue otherwise is to wander into the-sound-of-one-hand-clapping territory.    

But, but … the employer did not actually pay $5,000,000.
   

COMMENT: Sometimes the numbers go exponential. Mark Zuckerberg, for example, had options to purchase 120 million shares for just 6 cents per share when Facebook went public at $38 per share. The “but, but …” crowd would want to see a $4,550,000,000 check.

I admit: so would I. I would frame the check. After I cashed it. It would also be my Christmas card every year.

You are starting to understand why Silicon Valley start-up companies like nonqualified stock options. Their cost right now is nada, but it can be a very nice tax deduction down the road when the company hits it big.

I suspect that Soupman, Inc did something like the above.

They just forgot to send in Steve’s withholdings.

A Mom Taking Care Of A Disabled Child And Payroll Taxes

We have a responsible person payroll tax story to tell.

You may know that I sardonically refer to this penalty as the “big-boy” penalty. It applies when you have some authority and control over the deposit of payroll withholding taxes but do not remit them to the IRS. The IRS views this as theft, and they can be quite unforgiving. The penalty alone is equal to 100% of the tax; in addition, the IRS will come after you personally, if necessary.

You do not want this penalty – for any reason.

How do people get into this situation? In many – if not most cases – it is because the business is failing. There isn’t enough cash, and it is easier to “delay” paying the IRS rather than a vendor who has you on COD. You wind up using the IRS as a bank. Now, you might be able to survive this predicament if we were talking about personal or business income taxes. Introduce payroll – and payroll withholding – and you have a different answer altogether.

Our story involves Christina Fitzpatrick (Christina). Her husband made the decision to start a restaurant in Jacksonville with James Stamps (Stamps). They would be equal partners, and Stamps would run the show. Fitzpatrick would be the silent wallet.

They formed Dey Corp., Inc to hold the franchise. The franchise was, of course, the restaurant itself.  

Sure enough, shortly after formation and before opening, Stamps was pulled to Puerto Rico for business. This left Fitzpatrick, who in turn passed on some of the pre-opening duties to his wife, Christina.

Fortunately, Stamps got back in town before the place opened. He hired a general manager, a chef and other employees. He then went off to franchise training school. Meanwhile, the employees wanted to be paid, so Stamps had Christina contact Paychex and engage their services. They would run the payroll, cut checks and make the tax deposits.

            OBSERVATION: Let’s call this IRS point (1)

He also had Christina open a business bank account and include herself as a signatory.

            OBSERVATION: IRS point (2) and (3)

Stamps and the general manager (Chislett) pretty much ran the place. Whether he was in or out of town, Stamps was in daily contact with Chislett. Chislett managed, hired and fired, oversaw purchases and so on. He was also the main contact with Paychex.

Except that …

Paychex started off by delivering paychecks weekly to the restaurant. There was a problem, though: the restaurant wasn’t open when they went by. Paychex then starting going to Christina’s house. Chislett told her to sign and drop-off the paychecks at the restaurant. Chislett could not do it because it was his day off.

            OBSERVATION: IRS point (4) and (5).

You can anticipate how the story goes from here. The restaurant lost money. Chislett was spending like a wild man, to the extent that the vendors put him on COD. Somewhen in there Paychex drew on the bank account and the check bounced. Paychex stopped making tax deposits for the restaurants because – well, they were not going to make deposits with rubber checks.

By the way, neither Stamps nor Chislett bothered to tell the Fitzpatricks that Paychex was no longer making tax deposits.

Sure enough, the IRS Revenue Officer (RO) showed up. She clued the Fitzpatricks that the restaurant was over two years behind on tax deposits.

Remember that the restaurant was short on cash. Who could the IRS chase for its money in its stead?  Let me think ….

The RO decided Christina was a responsible person and assessed big bucks (approximately $140,000) against her personally.

Off to Tax Court they went.

The Court introduces us to Christina.

·       She spent her time taking care of her disabled son, who suffered from a rare metabolic disorder. As a consequence, he had severe autism, cerebral palsy and limited mobility. He needed assistance for many basic functions, such as eating and going to the bathroom. He could not be left alone for any significant amount of time.

·       Taking care of him took its toll on her. She developed spinal stenosis from constantly having to lift him. She herself took regular injections and epidurals.

·       She truly did not have a ton of time to put into her husband’s money-losing restaurant. At start-up she had a flurry of sorts, but after that she visited maybe once a week, and that for less than an hour.

·       She could not hire or fire. She was not the bookkeeper or accountant. She did not see the bank statements.

She did, unfortunately, sign a few of the checks.

The IRS looks very closely at who has signatory authority on the bank account. As far as they are concerned, one could write a check to them as easily as a check to a vendor. Christina appears to be behind the eight ball.

The Court noted that the IRS was relying heavily on the testimony of Stamps and Chislett.

The Court did not like them:

Petitioner’s cross-examination of Mr. Stamps and Mr. Chislett revealed that their testimony was unreliable and unbelievable."

That is Court-speak to say they lied.

Mr. Stamps evaded many of the petitioner’s questions during cross-examination by repeatedly responding ‘I don’t remember.’”

Sounds like a possible presidential run in there for Stamps.

The Court was not amused with the IRS Revenue Officer either:

However, we believe that RO Wells did not conduct a thorough investigation. For instance, RO Wells made her determination before she received and reviewed the relevant bank records. She also failed to interview (or summon) Mr. Stamps, the president of the corporation.”

The IRS is supposed to interview all the corporate officers. Sounds like this RO did not.

The Court continued:

We are in fact puzzled that Mr. Stamps, the president of the corporation and a hands-on owner, an Mr. Chislett, the day-to-day manager, successfully evaded in the administrative phase any personal liability for these TFRPs.”

My, that is curious, considering they RAN the place. The use of the word “evaded” clarifies what the Court thought of these two.

But there is more required to big-boy pants than just signing a check. The Court reminded the IRS that a responsible person must have some control:

The inquiry must focus on actual authority to control, not on trivial duties.”

Here is the hammer:

Notwithstanding petitioner’s signatory authority and her spousal relationship to one of the corporation’s owners, the substance of petitioner’s position was largely ministerial and she lacked actual authority.”

The Court liked Christina. The Court did not like Stamps and Chislett. They especially did not like the IRS wasting their time. She was a responsible person they way I am a deep-sea diver because I have previously been on a boat.

The Court dismissed the case.

But we see several points about this penalty:

(1)  The IRS will chase you like Khan chased Kirk.

(2)  Note that the IRS did not chase Stamps or Chislett. This tells me those two had no money, and the IRS was chasing the wallet.

(3)  Following on the heels of (2), do not count on the IRS being “fair.” They IRS can cull one person from the herd and assess the penalty in full. There is no requirement to assess everyone involved or keep the liability proportional among the responsible parties.

We have a success story, but look at the facts that it took.

Worst. Tax. Advice. Ever.

Dad owned a tool and die company. Son-in-law worked there. The company was facing severe foreign competition, and - sure enough - in time the company closed. For a couple of years the son-in-law was considerably underpaid, and dad wanted to make it up to him.

The company's accountant had dad infuse capital into the business. The accountant even recommended that the money be kept in a separate bank account. Son-in-law was allowed to tap into that account near-weekly to supplement his W-2. The accountant reasoned that - since the money came from dad - the transaction represented a gift from dad to son-in-law.

Let's go through the tax give-and-take on this.

In general, corporations do not make gifts. Now, do not misunderstand me: corporations can make donations but almost never a gift. Gifts are different from donations. Donations are deductible (within limits) by the payor and can be tax-free to the payee, if the payee has obtained that coveted 501(c)(3) status. Donations stay within the income tax system.

Gifts leave the income tax system, although they may be subject to a separate gift tax. Corporations, by the way, do not pay gift taxes, so the idea of a gift by a corporation does not make tax sense.

The classic gift case is Duberstein, where the Supreme Court decided that a gift must be made under a "detached and disinterested generosity" or "out of affection, respect, admiration, charity or like impulses." The key factor the Court was looking for is intent.

And it has been generally held that corporations do not have that "detached and disinterested" intent that Duberstein wants.  Albeit comprised of individuals, corporations are separate legal entities, created and existing under state law for a profit-seeking purpose. Within that context, it becomes quite difficult to argue that corporations can be "detached and disinterested."

It similarly is the reason - for example - that almost every job-related benefit will be taxable to an employee - unless the benefit can fit under narrow exceptions for nontaxable fringes or awards. If I give an employee a $50 Christmas debit card, I must include it in his/her W-2. The IRS sees an employer, an employee and very little chance that a $50 debit card would be for any reason other than that employment relationship.   

What did the accountant advise?

Make a cash payment to the son-in-law from corporate funds.

But the monies came from dad, you say.

It does not matter. The money lost its "dad-stamp" when it went into the business.

What about the separate bank account?

You mean that separate account titled in the company's name?

It certainly did not help that the son-in-law was undercompensated. The tax Code already wants to say that all payments to employees are a reward for past service or an incentive for future effort. Throw in an undercompensated employee and there is no hope.

The case is Hajek and the taxpayer lost. The son-in-law had compensation, although I suppose the corporation would have an offsetting tax deduction. However, remember that compensation requires FICA and income tax withholding - and no withholdings on the separate funds were remitted to the IRS - and you can see this story quickly going south. Payroll penalties are some of the worst in the tax Code.

What should the advisor have done?

Simple: have dad write the check to son-in-law. Leave the company out of it.

Pouring Concrete In Phoenix

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.