Hypothetical Independent Investor Test Tips the Scale in a Reasonable Compensation Case

Editor: Mark G. Cook, CPA, MBA

Expenses & Deductions

A common focus of IRS scrutiny is the reasonableness of compensation paid by closely held companies to owner-employees and their family members. The rationale for the additional scrutiny in the case of closely held C corporations is that shareholder-owners may be tempted to reduce or eliminate their company’s taxable income simply by increasing compensation paid to themselves, thereby eliminating the second tier of taxation on corporate income.

In such cases the IRS may challenge what they deem as unreasonably large salaries, bonuses, or other compensation, seeking to recharacterize some or all of the compensation as nondeductible, disguised dividends.

In a recent decision (Multi-Pak Corp., T.C. Memo. 2010-139), the Tax Court contemplated five factors in determining the reasonableness of a company’s sole shareholder’s compensation. At issue were two years, 2002 and 2003, in which the company deducted compensation paid to the shareholder in excess of $2 million each year. After considering the facts of the case in the context of the enumerated factors, the court found the shareholder’s 2002 compensation to be reasonable and fully deductible. However, the court partially sided with the IRS in determining that a reduction of deductible compensation was warranted for 2003. This result was largely due to the weight the court afforded one of the five factors considered in the case.

The Five Factors

The five broad factors considered by the Tax Court in rendering its Multi-Pak decision are explained in an often-cited decision (Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983)). The Elliotts court in turn distilled them from an earlier decision (Mayson Manufacturing Co., 178 F.2d 115 (6th Cir. 1949)).

The five factors are:

• The employee’s role in the company;
• An external comparison with other companies;
• The character and condition of the company;
• Potential conflicts of interest; and
• Internal consistency of compensation.

In Multi-Pak, the Tax Court gave considerable weight to the fourth factor—potential conflicts of interest—in the context of reasonable compensation from the perspective of a hypothetical independent investor.

In explaining its reasoning, the court gave deference to the Ninth Circuit’s analysis of the compensation issue in Elliotts: “If the company’s earnings on equity after payment of the compensation at issue remain at a level that would satisfy a hypothetical independent investor, there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary.”

Applying the Factors

In rendering its decision, the Tax Court analyzed the facts of the case, weighing each of the five Elliotts factors. Ultimately, it concluded that three of the factors supported the taxpayer’s contention that the salaries deducted during the years in question were reasonable, one factor was neutral, and only one factor—the potential conflict of interest test—favored the IRS’s position.

Role in the company—Services performed by the employee: This factor focuses on the employee’s importance to the success of the business. Pertinent considerations include the employee’s position, hours worked, and duties performed. During the years at issue, the sole shareholder served as Multi-Pak’s president, CEO, and COO. He controlled all aspects of the company’s operations, performed managerial duties, made all personnel decisions, and was in charge of price negotiations, product design, machine design and functionality, and administration. In 2002, the shareholder configured a new warehouse facility to accommodate the company’s expanding operations. In doing so, he drafted floor plans for the facilities, determined electrical distribution and compressed air filtration system requirements for each room, helped design the lighting system, and designed the warehouse layout and materials flow pattern. The shareholder devoted all of his time to the company’s operations and directly contributed to its financial condition. The court found that this factor weighed in the taxpayer’s favor.

External comparison—Competitive compensation analysis: This factor compares the employee’s compensation with that paid by similar companies for similar services. Expert witnesses were employed by both parties to support their respective positions. Each expert compared the shareholder’s compensation to compensation paid to employees of purportedly similarly situated companies to determine whether the compensation paid to the shareholder was commensurate with the services he provided the company. However, the court did not find the extensive analyses of the taxpayer’s or the IRS’s expert witnesses to be persuasive or reliable. Therefore, this factor was found to be neutral and did not sway the court’s decision in favor of either party.

Character and condition of the company: This factor focuses on a company’s size as measured by its sales, net income, or capital value; the complexities of the business; and general economic conditions that may influence the company’s performance. The court found Multi-Pak, Inc., to be prominent in its industry. Considering its increased equity, revenue, and gross profits, the court stated that it was “one of the more successful companies of its kind.” The court conferred this factor to the taxpayer’s favor.

Conflict of interest—The independent investor test: This factor examines whether a relationship exists between the company and the employee that would permit the company to disguise nondeductible corporate distributions as compensation payments. As mentioned above, close scrutiny may be warranted when the compensated employee controls the paying corporation. In keeping with the Ninth Circuit’s findings in Elliotts, the Tax Court held that the reasonableness of compensation in this case should be evaluated from the perspective of a hypothetical independent investor.

In Elliotts, where the taxpayer’s average rate of return on equity was 20%, the Ninth Circuit determined that the rate of return would satisfy a hypothetical independent investor. In its analysis of Multi-Pak, the Tax Court determined that the company’s operations resulted in 2.9% return on equity in 2002 and –15.8% in 2003, far from the acceptable rate of Elliotts. However, the court reasoned that an independent investor would consider other factors in determining an acceptable rate of return. In particular, the court surmised that an independent investor would note that the shareholder was instrumental in the financial success and the stability of Multi-Pak and that the company had little or no debt. Therefore, higher compensation would be merited and lower rates of return would be expected because of the relatively low risk associated with the investment. However, the court agreed with the IRS that the 15.8% negative rate of return of 2003 called into question the shareholder’s compensation for that year. Accordingly, the court found that its analysis of the conflict of interest factor favored the taxpayer for 2002 and favored the IRS for 2003.

Internal consistency of compensation: This factor weighs the consistency with which compensation policy is applied. According to Elliotts, evidence of an internal inconsistency in a company’s treatment of payments to employees may indicate that the payments go beyond reasonable compensation. Further, bonuses that have not been awarded under a structured, formal, consistently applied program can be suspect, yet evidence of a reasonable, longstanding, consistently applied compensation plan can be evidence that the compensation paid in the years in question was reasonable. In this instance, the taxpayer had a policy of paying monthly bonuses based on the company’s performance and profits each month to the shareholder and his three sons, who served as managers of the company. The IRS did not challenge the compensation of the shareholder’s sons in the years at issue. The Tax Court weighed the company’s monthly bonus program against one where bonuses would be determined at year end, when profitability would be known and there would be more temptation to disguise dividends as compensation. The court found that the taxpayer’s monthly bonus policy constituted a consistent compensation plan Thus, this factor weighed in the taxpayer’s favor.

Conclusion

The Tax Court weighed all five of the Elliotts factors in rendering its decision on the reasonableness of Multi-Pak’s shareholder-employee’s compensation in the years at issue. In doing so, the court determined that a majority of those factors prescribed an outcome favorable to the taxpayer. However, the court was compelled by its analysis of the independent investor test to decide against the taxpayer with respect to the compensation paid to the sole shareholder in 2003. In its analysis of the independent investor’s test, the court found that an independent investor would be willing to accept a reduced return on equity in light of the “impressive sales growth” and stability of a business. In this instance, a 2.9% return was deemed acceptable by the court for 2002. Conversely, the court found that the rate of return on equity of –15.8% in 2003 would not be acceptable to an independent investor. Accordingly, the court reduced the company’s deductible compensation paid to its CEO-shareholder for 2003. Presumably, the court’s conclusion would have been influenced one way or the other had it found the testimony of the compensation experts for either side to be relevant to the case. Regardless, the takeaway from this case should be that the return on equity test may sway the court’s decision even when the predominance of the other Elliotts factors may call for a different result.

EditorNotes

Mark Cook is a partner at Singer Lewak LLP in Irvine, CA.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with Singer Lewak LLP.