Common sense suggests that business owners, among their numerous tasks, should seek to minimize income taxes as they would any other expense, of course accommodating to the extent necessary the needs of their business. In this regard, building a documentary record to support the various tax positions being taken may preserve an income tax deduction that otherwise would be lost. More specifically, regarding a controlling business owner’s compensation, the opportunity to substantiate with relevant documentation the value of the services performed by the owner on behalf of the business should not be ignored.
A recent case suggesting the potential benefit of such planning is Clary Hood v. Commissioner, 69 F.4th 168 (4th Cir.2023), aff’d in part, etc., TCM 2022-15 (U.S. Tax Court 2022), involving the deductibility for income tax purposes of compensation paid to the business owner.
‘Hood’
Clary Hood, a talented entrepreneur and business owner, together with his wife, Gail Hood, established and successfully grew the business of Clary Hood, Inc. (the Company) from a modest two-person operation in 1980 to one employing 150 people and earning revenues of close to $70 million by 2016. Having grown up in and around his father’s construction business, where Clary devoted much attention to the grading and excavation of land, Clary and Gail struck out on their own in 1980 by forming the Company to specialize in land grading and excavation, generally as a subcontractor in various construction projects in South Carolina.
Clary served as the Company’s CEO, and together with Gail, owned all of the Company’s outstanding capital stock and served as the only members of the Company’s board of directors. Over the years, Clary demonstrated his devotion to the business, working long hours, rarely taking vacations and making the decisions necessary to nurture and grow the business. Typical traits of the successful entrepreneur!
The Tax Court acknowledged Clary’s “instrumental, if not exclusive role” in the Company’s successful navigating of the perils of the so-called “Great Recession,” which especially affected the Company’s taxable years 2009-2011.The Fourth Circuit described Clary’s particularly astute decision made in 2011 when revenues were about $21 million. Clary then decided, expressed the court, “… to pivot the company away from retail-related projects to other commercial and industrial projects … ” Clary’s decision resulted in an immediate increase in revenues, which rose to $44 million in 2015 and $69 million in 2016. See, Hood, at 171.
Jumping to the immediate issue, in 2015 and 2016, the Company paid Clary base salaries of $168,559 and $196,500, respectively, plus in each year bonuses of $5 million, all of which the Company considered as Clary’s compensation and deducted as such on its tax returns for said years. The IRS audited the Company’s tax returns and subsequently challenged Clary’s compensation as excessive, ultimately determining that the amount deductible in each year was $1,613,308.
Zeroing Out Profits
Generally, attempting to wipe out the profits of an operating business by increasing the owner’s compensation is a fraught, but not unusual, plan for owners of closely held “C corporations.” (A “C corporation” is one that has not elected Subchapter S status. See, Internal Revenue Code section 1361(a)(2).) Unlike an S corporation whose profits are taxable to the shareholders (see, Internal Revenue Code section 1366), the net profits of a business operated by a C corporation are taxable to the corporation itself (see, Internal Revenue Code section 11), and then taxable a second time when the profits are distributed to the shareholders (see, Internal Revenue Code section 301).
Payments, including amounts considered regular salary as well as bonuses, made by the corporation to its owners for services actually rendered are deductible for federal income tax purposes to the extent such compensation is reasonable under the circumstances. Internal Revenue Code section 162(a)(1); Treasury Regulations sections 1.162-7(b)(1), (3) and 1.162- 9.
The challenge is to determine what is reasonable in terms of compensation and yet be able to distinguish the portion of such payments, if any, that constitutes a distribution of the profits of the business. In Hood, the Fourth Circuit expounds on this issue.
Multiple Factors Testing Reasonableness
The big picture when controlling shareholders determine their own compensation is that a court is required to closely scrutinize all of the surrounding circumstances when determining the reasonableness of amounts paid as compensation. See, Hood, citing Dexsil v. Commissioner, 147 F.3d 96, 100 (2d Cir. 1998), to such effect.
A multi-factor test is generally applied by the federal circuit courts when determining whether amounts paid to a business owner as compensation are reasonable. It is important to note, however, that the circuit courts vary in the emphasis that they place on the various factors deemed relevant.
The Fourth Circuit, in deciding Hood, assessed the reasonableness of Clary’s compensation under the totality of the circumstances, taking into account a variety of factors while acknowledging that no single factor is generally decisive. The court considered the employee’s qualifications, the nature, extent, and scope of the employee’s work, the size and complexities of the business, a comparison of salaries paid with gross income and net income, the prevailing general economic conditions, comparison of salaries with distributions to stockholders, the prevailing rates of compensation for comparable positions in comparable concerns, the salary policy of the corporate taxpayer as to all employees, the amount of compensation paid to the particular employee in the previous years, and personal guaranties of debts or other obligations of the corporation.
Independent Investor
Another more controversial factor, briefly discussed in Hood, was whether a hypothetical independent investor would sanction the payment of a CEO-owner’s compensation, i.e., the so-called “independent investor” test. Generally this test, which is applied by some courts in lieu of the multi-factor test, presumes that if a company’s return on equity (taking into account the amount of the compensation) is satisfactory to an independent investor, the compensation is per se reasonable and, therefore, deductible under Internal Revenue Code section 162, even though it exceeds the amount that would otherwise be deemed reasonable under the multi-factor test. Although acknowledging the substantial increase in the Company’s shareholder equity due to Clary’s efforts, the Fourth Circuit continued to abide by the multi-factor test.
Notable Points
There is value in knowing the negative influence on the Tax Court of the following findings:
- The Company, despite its profitable years, had never declared or paid a cash dividend.
- The Company did not have a written employment agreement with Clary.
- Clary’s compensation was set by Clary and Gail as the sole members of the Company’s board of directors.
- The Company lent money and extended credit to both Clary and his other business ventures.
- The Company’s compensation expert witnesses lacked credibility.
In determining Clary’s compensation for 2015 and 2016, Clary and Gail relied on advice of the Company’s financial officer and its outside accountants who, among other things, determined that Clary had previously been undercompensated for his efforts as well as not compensated for his personal guarantees of Company loans, credit lines and capital leases, providing some room for make-up payments.
The Opportunity to Build the Record
It is an opportunity for controlling business owners to help establish the bona tides of their compensation. In other words, it is the chance to build the foundation to support the finding that the amounts received as compensation are reasonable and therefore deductible for income tax purposes. For starters, thought should be given to modifying the provisions of the company’s by-laws to establish a board approval process to apply in the case of executive compensation. Adopting a decision structure which allows for consideration of an independent voice and credible comparability studies should go a long way to building the necessary record.
Consideration should also be given to the company’s having a written employment agreement with the owner providing, among other things, for base salary and bonuses using a formula based upon company profits, for example. In addition, it should be helpful for the company to follow the corporate formalities such as holding regular director’s meetings and memorializing them in writing with minutes, including minutes that approve executive salaries and bonuses as well as other relevant corporate actions. If nothing else, these items would be business records and therefore perhaps constitute favorable documentary evidence.
Although determining the appropriate compensation for a controlling business owner in any given circumstance may be more art than science, it clearly seems to be worth the effort to provide the groundwork for the package.
Reprinted with permission from the New York Law Journal, An ALM Publication