While this can be an effective tax-planning tool, it can also be a bit egregious at times. Remember, while Section 162 allows taxpayers to deduct ordinary and necessary expenses, it requires compensation deductions to be “reasonable.”
In Mulcahy, Pauritsch, Savador & Co. v Commissioner, T.C. Memo 2011-74, one accounting firm found out that it’s not important that compensation payments be “reasonable” in terms of the employer’s ability to pay them, but rather they must be reasonable compensation for the services provided. In other words, just because a corporation can afford to pay a shareholder/employee $300,000, doesn’t mean the shareholder’s services were worth $300,000.
The firm in Mulcahy had six shareholders; three of which were founders. The firm paid compensation to each of the founders in the neighborhood of $10oK each, but also made “consulting” payments to three affiliated entities owned by the founders of nearly $1,000,000. These consulting payments reduced the firm’s income each year to near zero.
The IRS challenged the deduction for the consulting payments, based primarily on the fact that the affiliated entities didn’t actually provide any services to the firm.
The Tax Court sided with the IRS on that issue, but also examined the payments as if they were made directly to the founders. Again, the payments were held to represent unreasonable, nondeductible compensation for the following reasons:
1. The firm’s rate of return (net income/equity) was too low to support the amount of compensation paid. An independent investor would not be pleased with the compensation paid to the firm’s shareholders when compared to his return on investment.
2. While the firm argued that the founders should be paid substantially more than nonshareholder employees, it did not show that the founders actually provided more services than the nonshareholder employees.
3. The intent of the firm was not to compensate for services, but rather to distribute the firm’s profits for tax planning purposes.
A couple of observations about the court’s decision:
First, the analysis in #2 above is the polar opposite of the argument the IRS makes in scrutinizing reasonable compensation for S corporation shareholders. In those cases, if the shareholder-employee is not paid more than nonshareholder-employees, it is a strong indication that their compensation is not reasonably high enough. Yet here, where the shareholder-employees were paid more than nonshareholders, the court refused to consider that a factor in their favor.
Second, the case law related to C corporation reasonable compensation makes clear that shareholder-employees can be paid compensation in a current year as a “catch-up” for services provided in prior years when the corporation couldn’t afford to pay fair compensation. This factor was not even discussed here.
Lastly, when the consulting payments were received by the affiliated companies, these companies in turn made payments to the founders based on their hours worked, not based on their shareholder interests in the firm. Under Treas. Reg. Section 1.162-7(b)(1), this would be an indication taht the payments to the shareholder-employees were not profit distributions, since they weren’t made in proportion to their ownership shares. The court gave this favorable evidence no weight.
The case history regarding reasonable compensation is a long and thorough one. Unfortunately, the court’s decision in Mulcahy creates more questions than answers.