How compensatory intent affects compensation deductions

It is well known that the tax laws create limits on the amounts that corporations can treat as compensation paid to their shareholder/employees. When an S corporation, C corporation, or charitable organization pays an unreasonable amount, the IRS may disallow part or all of a deduction for compensation and may impose penalties. Besides the amount of compensation paid, the payer’s intent is scrutinized.

Regs. Sec. 1.162-7(a) states, “There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered.” The phrase “for personal services actually rendered” refers to the intent behind the transaction.

For reasons why corporations might have an impermissible tax motive to either overpay or underpay their shareholder/employees and how CPAs can advise them on what constitutes reasonable compensation, see my earlier articles, “Helping S Corporations Avoid Unreasonable Compensation Audits,” 219-6 Journal of Accountancy 54 (June 2015), and “Preventing a Challenge to (Un)reasonable Compensation,” 216-3 Journal of Accountancy 58 (September 2013). See also DiGiantommaso, “Items and Factors to Consider in Setting Reasonable Compensation,” 49 The Tax Adviser 49 (January 2018). The present article focuses on how compensatory intent affects compensation deductions.

Establishing intent

In court opinions where compensatory intent has been addressed, the existence of (or lack of) intent was determined primarily by records created by the payers. Close attention has been given to descriptions in board minutes; whether payments were included on payroll tax returns; whether income taxes were withheld; whether the amounts were included on a Form W-2, Wage and Tax Statement; and whether the payments were recorded as compensation expense on financial statements.

The Tax Court clearly explained its rationale in Paula Construction Co., 58 T.C. 1055 (1972), aff’d, 474 F.2d 1345 (5th Cir. 1973). This case involved a company that had been an S corporation. However, its S status was terminated due to the large amount of interest income it had received. Thinking their company was still an S corporation, two shareholder/employees recorded payments to themselves as distributions, not as compensation, in the corporate books and tax returns. After learning that their company had inadvertently become a C corporation, they attempted to convert the distributions to compensation expense to avoid the double taxation that would apply to C corporation dividends.

However, the Tax Court rejected that treatment, since the company had not shown compensatory intent at the time the distributions were made. “There was no corporate authorization for the payment of salaries, and in the books and records of the corporation, the disbursements were not treated as payments of compensation,” the court stated. “The record contains no indication that any sums were reported on W-2 forms.” The Tax Court’s opinion also stated, “It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation. Whether such intent has been demonstrated is a factual question to be decided on the basis of the particular facts and circumstances of the case” (citations omitted). The court also said that “the fact that [the two shareholders] performed services establishes merely that they could have been paid compensation which would have been deductible; it does not establish that the distributions to [them] were intended as compensation.” Although it was clear that the shareholder/employees had performed valuable services, “nothing in the record indicates that compensation was either paid or intended to be paid.” The court concluded that “we must decide the case in the light of what was done, not what might have been done.”

A test that has been applied in many cases determining reasonable compensation is that enunciated in Elliotts Inc., 716 F.2d 1241 (9th Cir. 1983). Its factors are:

1. The employee’s role in the company, including hours worked and duties performed;
2. How the compensation compares with that paid by similar companies for similar services;
3. The company’s character and condition, as evidenced by its sales, net income, capital value, and other relevant indicators;
4. A relationship between the company and employee amounting to a conflict of interest that allows the company to disguise distributions as salary; and
5. The compensation’s consistency with pay to other employees.

Company loans and guarantees

Similar issues arise when a company’s loans to its shareholders are examined. If the IRS determines that a purported loan to a shareholder/employee does not have enough characteristics of a bona fide loan, the amount could be converted to a distribution from an S corporation or a dividend from a C corporation. See Glass Blocks Unlimited, T.C. Memo. 2013-180, for 13 factors that courts have considered when determining the proper classification of a purported loan. These are:

1. The names on documents evidencing the purported loans;
2. Whether there is a fixed loan maturity date;
3. The likely source of repayment;
4. The right to enforce payments;
5. Participation in management as a result;
6. Subordination of the purported loan to loans of the corporation’s creditors;
7. The parties’ intent;
8. The corporation’s capitalization;
9. The corporation’s ability to obtain credit from outside sources;
10. Thinness of the corporation’s capital structure in relation to debt;
11.  Use of the funds;
12.  Whether the corporation repaid the funds; and
13.  The risk involved in transferring the funds (citing Calumet Industries, Inc., 95 T.C. 257 (1990)).

The payer and payee may prefer converting the so-called loan to compensation rather than to a distribution, but that may not be an option without showing there was compensatory intent when the original transfer occurred.

Closely held businesses also often pay fees to shareholders who personally guarantee company debts and leases (for more on this, see my earlier article “Paying for Personal Guaranties of Company Debts,” 53-9 The Tax Adviser 7 (September 2022)). However, for the Tax Court to respect any such payment as deductible compensation, the guarantor must have demanded compensation for such a guarantee, among other factors. Otherwise, the company may not be able to show that any specific payment was intended to compensate for such guarantees. See Clary Hood, Inc., T.C. Memo. 2022-15, aff’d, 69 F.4th 168 (4th Cir. 2023).

Catch-up and intercompany payments

Intent has also been a pivotal issue when companies claimed that they had made catch-up payments to make up for earlier years in which shareholders/employees had been undercompensated. The Tax Court has acknowledged that many startups wait to make such catch-up payments once they become financially stable. However, the companies must be prepared to show that certain payments were intended to compensate for earlier services. Otherwise, the full amount paid in each year is considered to have been paid only for that year’s services.

In Choate Construction Co., T.C. Memo. 1997-495, the Tax Court held that catch-up pay resulted in a deduction in the company’s third year of operation. The court concluded, “If a taxpayer otherwise qualifies, it may deduct catchup pay. The fact that petitioner could provide catchup pay quickly is another measure of Choate’s success.” However, catch-up pay was held not deductible in Universal Manufacturing Co., T.C. Memo. 1994-367, or Eberl’s Claim Service Inc., T.C. Memo. 1999-211, aff’d, 249 F.3d 994 (10th Cir. 2001), due to lack of demonstrated intent to compensate for prior services.

Even payments between corporations must have compensatory intent to be deductible as payment for services rendered. See International Capital Holding Corp., T.C. Memo. 2002-109. In this case, as well as in Paula Construction, the court stated that both the payer and the payee must understand that a payment is being made for services provided (among other factors). In Aspro, Inc., 32 F.4th 673 (8th Cir. 2022), aff’g T.C. Memo. 2021-8, the Eighth Circuit did not allow a deduction for “management fees” paid to two corporations as shareholders when neither corporation had billed Aspro nor sent invoices for any services performed and there were no written agreements for consulting services. 

The bottom line is that the way a corporation treats a payment to an owner or to an affiliate is not binding on the Service or the courts. And payments without the indicia of compensatory intent may be reclassed as something other than deductible expenses.

— Stephen D. Kirkland, CPA/CFF, is the founder of Atlantic Executive Consulting LLC in Columbia, S.C. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld.