Double Tax

The shareholders of C corporations have long sought legitimate operational and transactional structures by which they may reduce the double tax hit that is realized when such a corporation distributes its after-tax operating profits or its after-tax sale proceeds to its shareholders.[i]

Sale of Assets

The gain recognized when a C corporation sells its assets, for example, is subject to a corporate-level federal income tax at a flat rate of 21 percent.[ii]  When the corporation makes a liquidating distribution of the after-tax sale proceeds to an individual shareholder,[iii] the gain recognized by the shareholder is subject to a shareholder-level federal income tax of 20 percent,[iv] plus a 3.8 percent net investment income surtax.[v]

Bypass the Corp

To reduce this tax burden many advisers will consider whether the C corporation may somehow be bypassed; meaning, whether the buyer can make any payments directly to the corporation’s shareholders rather than to the corporation. Depending upon the facts and circumstances – and provided there is a bona fide business reason for a direct payment to the shareholder, and provided further that the amount paid is reasonable[vi] – a consulting, employment, or noncompete agreement for a former shareholder may be appropriate; the leasing or licensing of property owned by the shareholder outside the corporation[vii] but that is used in the corporation’s business may also be a viable option; finally, the sale of a shareholder’s personal goodwill (assuming it can be substantiated) presents yet another avenue for avoiding the corporate-level income tax and, thereby, reducing the double tax hit.[viii]

Ongoing Corporate Business

As in the case of the distribution of sale proceeds, the corporation’s distribution of a dividend does not reduce its taxable income, and the amount of the dividend is taxable to the individual shareholders to whom it is made.[ix] Thus, the operating profits that are taxed to the corporation are then also taxed to the shareholders when distributed to them.[x]

Many of the bypass-payment alternatives mentioned above are also available to the C corporation as an ongoing business. For example, if the corporation operates in a building owned by one or more of its shareholders,[xi] it may pay rent to such owners for the use of the property. The corporation would claim a tax deduction for the rental payment, while shifting income to the shareholder-lessor.

The method most commonly utilized by a corporation as a going concern to transfer profits to its shareholders while also reducing its own tax liability is through the payment of compensation to its shareholder-employees.

Reasonable Compensation

Among the “ordinary and necessary” expenses paid or incurred by a corporation in carrying on its trade or business, and for which it may claim a tax deduction, is a reasonable allowance for salaries or other compensation paid in exchange for personal services actually rendered by its employees and other service providers, including shareholders who act in those capacities.[xii] The test of deductibility in the case of such compensatory payments is whether they are reasonable and are in fact payments purely for services.

Any amount paid in the form of compensation, but not in fact as the “purchase price” of services, is not deductible as such. An ostensible salary paid by a corporation may actually represent a distribution of a dividend on stock.[xiii] This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries.[xiv] If, in such a case, the salaries are in excess of those ordinarily paid for similar services – i.e., they are unreasonable – and the excessive payments correspond, or bear a close relationship, to the stockholdings of the service-providers, it would seem likely that the so-called salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the corporation’s stock.

In general, an amount of compensation is reasonable if it “would ordinarily be paid for like services by like enterprises under like circumstances.” Even under ideal conditions, this determination is anything but straightforward.[xv] This should come as no surprise when one realizes that the exercise is equivalent to determining the fair market value of the service in question.[xvi] It becomes especially difficult, when the shareholder-employee whose compensation is being determined is the founder of the business and its principal player, as was demonstrated in a recent decision of the U.S. Tax Court.[xvii]

A Success Story

Shareholder dedicated his entire adult life to the construction industry. Many years ago, he organized Corp, which was treated as a C corporation for tax purposes. Shareholder held ultimate decisional control over all of Corp’s operations from its founding through the years at issue.

Risk and Sacrifice

During those years, Corp faced many challenges and undertook some significant risks. However, while many of its competitors folded during this period, Corp survived in no small part because of certain key decisions in which Shareholder played an instrumental, if not exclusive, role: (1) conserving cash outlays by maintaining a low debt profile and not declaring dividends; (2) temporarily reducing employee pay; and (3) withholding Shareholder’s salary, when necessary, to ensure that sufficient funds were available to cover Corp’s payroll needs.

In addition to these measures, and primarily through Shareholder’s efforts, Corp diversified its customer base by transitioning from retail-related work to the commercial and industrial market sectors. As a result of this strategy, Corp’s revenue growth and financial performance skyrocketed.

Even after its tremendous financial success, however, Corp never declared or paid a cash dividend to its shareholders (i.e., Shareholder and his spouse) at any time during the “review period” (as defined below).


Shareholder held various titles with Corp during the review period, but his duties remained relatively constant: (1) oversight of Corp’s fleet of equipment (procurement, use, maintenance, and disposition); (2) hiring, training, and supervision of mechanics; (3) supervision and inspection of jobsites; (4) preparation, review, and approval of job estimates and budgets; (5) submission and negotiation of job bids; (6) setting of employee salaries and bonuses; and (7) acquisition of bonding for projects. Shareholder rarely took vacations and typically worked 60-70 hours per week (including weekends).[xviii]

While Shareholder’s leadership and work ethic contributed to Corp’s exponential growth, Corp’s success would have been “fleeting if not for the hard work and dedication” of Corp’s other executives, several of whom served in multiple capacities (similar to Shareholder’s), and whose work habits seem to have matched Shareholder’s.


Under Corp’s agreement with its bonding companies, Shareholder agreed to guarantee any claim the bonding companies may have had against Corp during the review period for amounts beyond Corp’s ability to pay. Shareholder also agreed to personally guarantee payment of some of Corp’s business loans, credit lines, and capital leases during the review period.

Shareholder’s Compensation

No written employment agreement existed between Shareholder and Corp during the review period. Rather, Corp’s board of directors, which comprised solely Shareholder and his spouse, set the amount of Shareholder’s annual compensation, including bonuses.[xix] Although Shareholder and his spouse generally solicited and accepted the advice of Corp’s accountants, they did not use any type of formula in setting these compensation amounts during the review period.

Before the years at issue,[xx] Corp never compensated Shareholder for the debt guaranties or surety bond guaranties.


Just prior to the tax years in question, however, one of Corp’s officers raised the issue of Shareholder’s historic compensation with Corp’s accountants; specifically, this officer believed that Shareholder had been undercompensated in prior years (the “review period”) and sought advice on how to compensate Shareholder moving forward.[xxi] In response to this inquiry, Corp’s accountants provided a summary of salary surveys.

Using this survey information, the officer began to perform preliminary computations to determine the amount by which Corp had undercompensated Shareholder during the review period. The officer, Shareholder, and the accountants then discussed the issue of Shareholder’s historic compensation.

They all agreed that Shareholder had been undercompensated during the review period for the services he had rendered to Corp and that he deserved a bonus in the amount of $5 million in respect of such prior services, pending follow-up analyses. The $5 million amount was supported by a “compensation due” spreadsheet which set forth a model with Corp’s income statements for each year of the review period, Shareholder’s annual reported compensation for each of those years as shown on its federal tax returns, and a series of related items for each year labeled “[Shareholder] Calculated Compensation.”

The “[Shareholder] Calculated Compensation” items comprised the following: (1) a base salary at the start of the review period, then increasing 5% annually; (2) an annual bonus of 20% of Corp’s profits before taxes; (3) an annual fee of $100,000 for bonding guaranties; and (4) an annual debt guaranty fee equal to approximately 1% of the debt and capital leases personally guaranteed by Shareholder.

The spreadsheet also incorporated data from the above-referenced salary surveys. The accountants also provided secondary research on the topic of reasonable executive compensation and modified the “compensation due” spreadsheet by adding as line items below the income statements a “Total Equity” figure and a “Return on Equity for the year” calculation for each year during the review period.

Through these inputs and calculations, the model arrived at a proposed bonus figure of $5 million for Shareholder.

Corp’s board of directors held a meeting in which the board approved a $5 million bonus to Shareholder for the first tax year in question. In support of this decision, the board minutes listed as consideration many of the prior services rendered by Shareholder, including the following: (1) navigating the business and changing its direction to more industrial opportunities; (2) “[d]ealing [with] and reacting to the most severe recession faced by the [c]ompany” (the “Great Recession”); (3) “personally guaranteeing most or all of” Corp’s debt, capital leases, and credit lines since inception; (4) acting as the “[p]ersonal guarantor to [Corp’s] bonding company since inception”; (5) “[p]roviding a steadying influence to both customers, vendors, and, most importantly, employees”; (6) “leading the [c]ompany by being prudent in seeking job opportunities and the purchasing of equipment necessary to handle the [c]ompany’s emergent work opportunities”; (7) “personally overseeing that equipment used by Corp on job sites met or exceeded expectations in the performance of the job”; and (8) “managing and leading the [c]ompany over the most profitable four year run in its existence.” The compensation due spreadsheet was attached to the board meeting minutes.

The following tax year, the board approved a second $5 million bonus payment to Shareholder, relying upon the same factors set forth above.

Off to Court

Following an audit of Corp’s federal income tax returns[xxii] for the two tax years in question (the bonus payment years), the IRS timely issued a notice of deficiency[xxiii] to Corp for such years. The notice determined that portions of Shareholder’s purported compensation for those years exceeded reasonable compensation and disallowed the deduction claimed by Corp for these portions, thereby resulting in corporate income tax deficiencies for those years.

In response to the notice of deficiency, Corp timely filed a petition with the Tax Court disputing the disallowed compensation deductions.[xxiv]

Burden of Proof

The Court began by stating that the IRS’s determinations set forth in a notice of deficiency are generally presumed correct and the taxpayer bears the burden of proving that the determinations are in error.[xxv] The Court then added that the taxpayer bears the burden of proving entitlement to any deduction claimed, including for employee compensation paid greater than that determined by the IRS.

The Court explained that Corp, a C corporation, was subject to federal income tax on its taxable income, which is its gross income less allowable deductions.[xxvi] A corporation, it stated, may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation; for example, bonuses for personal services actually rendered.[xxvii]

Reasonable Comp?

Whether payments are “reasonable” and purely for services, the Court continued, is a question of fact to be determined from all the facts and circumstances of each particular case.[xxviii]

An employer may deduct compensation paid to an employee in a year although the employee may have performed the services in a prior year. The employer must demonstrate that the employee was not sufficiently compensated in the prior year and that the current year’s compensation was in fact to compensate for that underpayment.

Another consideration is whether the employee was also a shareholder of the corporation. The Court observed that where director/officer-shareholders are in control of a closely held corporation and set their own compensation, careful scrutiny is required to determine whether the alleged deductible compensation is in fact a nondeductible dividend.[xxix]

An “ostensible salary” paid by a closely held corporation to one of its few shareholders is likely to constitute a disguised dividend, the Court observed, where the amount is “in excess of what would ordinarily be paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees.”[xxx]

Multi-factor Test

The Court noted that the U.S. Court of Appeals to which an appeal of this case would lie,[xxxi] requires consideration of multiple factors in determining reasonable compensation: 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; a comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; and the salary policy of the employer-taxpayer as to all its employees.

In the context of small corporations with a limited number of officers, additional factors may include the amount of compensation paid to the particular employee in previous years, and personal guaranties of debts or other obligations of the corporation.

According to the Court, no single factor is decisive; instead, one has to consider and weigh “the totality of the facts and circumstances when making a decision.” In doing so, the Court stated it may find certain factors less relevant than other factors when considering the facts necessary to reach a conclusion.[xxxii]

Determining Shareholder’s Value

There was no doubt, the Court affirmed, that Shareholder’s efforts directly contributed to Corp’s prosperity during the review period. Furthermore, the parties did not dispute that Shareholder was entitled to some degree of additional compensation for the prior services he rendered as an employee of Corp during portions of the review period.[xxxiii]

That said, the IRS challenged from a federal income tax perspective whether the dramatic increase in Shareholder’s purported compensation in the two tax years in question constituted deductible compensation or a disguised dividend.

Qualifications. The Court acknowledged that an employee’s superior qualifications for their position may justify higher compensation. With approximately 50 years of relevant work experience, Shareholder had substantial managerial experience and working knowledge in Corp’s business. Furthermore, he had developed an excellent reputation in Corp’s market, which allowed the company to compete for, and win, jobs.

Duties. Likewise, the Court recognized that an employee’s position, duties performed, hours worked, and general importance to a corporation’s success may justify higher compensation. Shareholder was Corp’s key employee and its driving force from its inception, and his personal services were essential to Corp’s success. He managed and built Corp’s business, solicited, and obtained jobs, and supervised all work performed. Furthermore, he made the pivotal decision to transition to the commercial and industrial market sectors, which led to Corp’s significant financial growth.

Size/Complexity of the Business. The Court also observed that the size[xxxiv] and complexity of a taxpayer’s business may be considered when deciding the reasonableness of compensation paid to its shareholder-employees. Corp experienced exceptional growth in terms of both employees and revenue during the review period. The workforce almost doubled, and annual revenue increased nearly eightfold. Moreover, Corp’s work was more complex and specialized than that of a general construction company. Through Shareholder’s contributions, Corp created a niche by competing in a cost-effective manner and developed a strong reputation in its market.

Compensation as Percentage of Profit. The Court then considered Shareholder’s compensation as a percentage of Corp’s net income[xxxv] because, the Court noted, it “more accurately gauges whether a corporation is disguising the distribution of dividends as compensation.” A corporate taxpayer’s pattern of attempting to distribute a significant portion of its net pretax income as deductible compensation to employee-shareholders rather than as nondeductible dividends such that the corporation has relatively little taxable income after deducting the “compensation” may be an indication that the corporation is disguising dividends as compensation.

However, the Court added that no particular ratio of compensation-to-net taxable income was a prerequisite for a finding of reasonableness. Corp paid approximately 40% and 25% of its pretax income to Shareholder as purported compensation in the two tax years before the Court, respectively. While such amounts were not insignificant, the Court did not find them “telling of an egregious pattern of disguised dividends as traditionally understood” when considering that such amounts are principally meant to reflect compensation for Shareholder’s prior years of service during the review period.

Economic Conditions. Next, the Court looked at prevailing economic conditions to determine whether the success of Corp’s business may be attributable to Shareholder’s efforts and business acumen, as opposed to general economic conditions. According to the Court, adverse economic conditions tend to show that an employee’s skill was important to a company that grew during bad economic years.

Corp’s revenue increased significantly during the review period, a trend that the Court stated could not be credited to economic conditions alone.[xxxvi] For that reason, it continued, it was fitting to recognize Shareholder’s contributions to Corp’s success outside of general economic conditions. Shareholder also testified that, although Corp’s poorest performance years were predominantly attributable to years of national economic contractions, many of Corp’s competitors went out of business during these economic downturns. Shareholder, on the other hand, took active measures as CEO to ensure Corp’s survival during such periods by selling equipment, reducing employee compensation, including his own when needed, and conserving financial resources. Such actions further illustrated the importance of Shareholder’s role within the company even during economically turbulent years.

Dividends. The Court observed there was no legal requirement for a corporation to pay dividends; in fact, it added, many shareholders are often “content with the appreciation in the value of their stock that arises through retention of earnings.”

However, a complete absence of dividends to shareholders out of available profits justified an inference that some of the purported compensation paid to a shareholder-employee represented a distribution of profits.

Corp was profitable during the review period, and especially in the years under examination, but never declared or paid a cash dividend. Some of Corp’s asserted reasons for not doing so (for example, to meet working capital needs during the Great Recession and maintain a competitive edge through strong balance sheets), were persuasive when considering years in which business was slow and capital needs were high.

However, according to the Court, these reasons could be carried only so far before “losing their appeal” after taking into account: (1) Shareholder’s decision, as Corp’s controlling shareholder, to defer “monetary recognition” through a dividend for his investment for so many years, and (2) Corp’s decision to not recognize those “deferrals” through a dividend but instead through a purported bonus after it had acquired sufficient capital and cash in the years at issue to do so.[xxxvii]

Comparables. The Court next considered Shareholder’s compensation in comparison to that paid to persons holding comparable positions in comparable companies.[xxxviii] It reviewed the testimony of the parties’ expert witnesses[xxxix] and concluded that the report prepared by the IRS’s expert most accurately accounted for all known amounts of purported compensation paid to Shareholder during the review period and contained detailed disclosures of data sources relied upon, methodologies used, and supporting calculations. Thus, the Court determined that this report was the most credible and the most complete; it also offered a well-reasoned comparison, the Court stated, of Shareholder’s salary against industry standards, including what similar companies might have been willing to pay Shareholder on Corp’s facts.

Corp, however, contended that Shareholder’s role in Corp’s growth and success should be seen as “extraordinary or unique” such that industry comparisons could not be relied upon.  The Court agreed that Shareholder was extraordinarily talented in his industry and that perhaps few other individuals could have achieved similar results for Corp during the review period.

Other Employees. Finally, the Court considered salaries paid by Corp to other employees of the business to determine whether Shareholder was compensated differently from Corp’s other employees solely because of his status as a shareholder.

Corp had no structured system in place for setting the compensation of its non-shareholder employees. Shareholder personally set the salary and bonus amounts of other employees and officers; he testified that he based these decisions on his own subjective belief as to the individual’s “work records”, “ability to get along with people”, and “pride in the company.”

Shareholder’s salary and bonus in the years at issue represented almost 90 percent of the total amount of compensation that Corp paid to its officers despite the fact that non-shareholder officers worked nearly the same number of hours as Shareholder and shared in many of Shareholder’s responsibilities.

Moreover, Corp had no agreement in place with Shareholder regarding his compensation; his compensation during the review period was instead set by him along with his spouse in their roles as Corp’s board of directors. Because such conditions could be “ripe for the existence of disguised dividends,” the Court examined the specific circumstances surrounding the setting of Shareholder’s compensation for the years at issue.

The Bonuses

The bonus for the first tax year in question was initially proposed near the end of such tax year at a meeting with one of Corp’s officers, Shareholder, and Corp’s external advisers, in which the bonus amount of $5 million was tentatively agreed on. In arriving at this amount, the Court observed, Corp and its advisers had the advantage of knowing its anticipated year-end profits for that tax year, which was expected to be the most successful in Corp’s history. Despite the fact that Corp never paid Shareholder a dividend, Corp continued with its plan to award him only a purported bonus.

What’s more, according to the Court, Corp “used its own performance as a proxy for” Shareholder’s performance with the board minutes citing only Shareholder’s overarching contributions to Corp over the review period without any attempt to value the specific services rendered by Shareholder, other than his debt guaranties.

Although such a comparison may make sense, the Court stated, for “a one-man enterprise,” Corp employed dozens of employees during the review period and conceded that its growth during this time could not be tied exclusively to Shareholder’s efforts. Indeed, Corp did not provide evidence to support what portion of the company’s growth could reasonably be attached to each of the various services, including possible values thereof, rendered by Shareholder during the review period as opposed to that of the other officers and employees.

In awarding Shareholder the bonus for the second year in question, Corp acted under the awareness that, on the basis of its preliminary financials, this tax year was to be even more profitable than the last. Nevertheless, Corp again chose not to declare a dividend but instead to reward Shareholder exclusively through another $5 million bonus, reciting the same underlying rationale it provided for the prior amount but without any attempt at explaining why the prior bonus had been insufficient “backpay compensation” for Shareholder’s prior services during the review period. This absence was particularly notable, the Court observed, when considering that the record also did not show that, when awarding Shareholder the first bonus, Corp felt he remained undercompensated or that additional backpay compensation might be warranted in the future for these prior year services.

The Court’s Conclusion

Where a large salary increase is in issue, the Court stated, “it may be useful to compare past and present duties and salary payments, to determine whether and to what extent the current payments represent compensation for services performed in prior years that can be currently deductible.” Shareholder’s total purported compensation, the Court stated, increased over 300 percent in the first tax year at issue, which was Corp’s most profitable year to date, yet there was no corresponding increase in Shareholder’s responsibilities in that year. The stated justification per the corporate minutes for this increase was that Shareholder was undercompensated in prior years.

While the Court did not disagree that Shareholder was undercompensated in certain years of the review period, this did not entitle Corp to “carte blanche in deducting” Shareholder’s backpay bonus amount. The Court added that it viewed the above-referenced board minutes with a certain degree of skepticism.

Moreover, the Court found that Corp did not sufficiently demonstrate through reliable means how the full amount of each of the two bonuses was proportionate in value to the purported past services rendered by Shareholder.[xl]

Having considered the totality of the factors discussed above, the Court concluded that Corp did not adequately establish how the amounts paid to Shareholder during the years at issue were both reasonable and paid solely as compensation for his services to Corp during the review period. While certain factors favored Corp, the Court did not “simply sum which party had the most factors in reaching” its conclusion as not all factors were afforded equal weight. The Court the factors addressing comparable pay by comparable concerns, Corp’s shareholder distribution history, the setting of Shareholder’s compensation in the years at issue, and his involvement in Corp’s business, were the most relevant and persuasive factors.

Accordingly, the Court held that the record supported reasonable compensation of an amount that was less than the bonuses paid, albeit more than the amount claimed by the IRS.


By now, it should be obvious to all but the most oblivious of business owners and advisers that the owners of a closely held business must treat with their business at arm’s-length, regardless of its form of organization. The failure to do so in the case of a C corporation may result in the disallowance of deductions claimed by the corporation in determining its income tax liability.

As we saw in the discussion above, where the transaction between the corporation and its owners involves the rendering of services by one or more of the owners to the corporation, it is imperative that the services actually be provided[xli] and that the compensation payable to the owner for such services be reasonable.

The time for determining the reasonableness of compensation is not after the IRS has selected the corporation’s tax return for examination; rather, the appropriateness of the amount to be paid to a shareholder-employee should be determined contemporaneously with the services rendered or to be rendered.

In making this determination, the board of the closely held corporation should consider the factors set forth in the Court’s opinion described above. In addition, and in order to address the inherent conflict where the decision-maker is also the employee – and also as a check on the amount otherwise arrived at – the shareholder-employee should evaluate the compensation from the perspective of a hypothetical independent investor, focusing on the investor’s return on equity. If the company’s earnings on equity after payment of compensation are at a level that would satisfy an independent investor, there is a strong indication that the employee is providing compensable services and that profits are not being siphoned out of the company disguised as salary.

Finally, the foregoing efforts and the conclusion drawn therefrom should be memorialized in writing.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Of course, the S corporation election may be available to the corporation and its shareholders. IRC Sec. 1361 and 1362. However, there are also many reasons why the election may not be an option, including the presence of an ineligible shareholder (for example, a partnership) or of an outstanding class of preferred stock.

[ii] IRC Sec. 11.

[iii] The timing for such a liquidation may depend on many factors; for example, the indemnity survival period under the purchase and sale agreement, or the receipt of an installment obligation in partial consideration for its assets – the distribution of the note would accelerate recognition of the gain that would otherwise be deferred under the installment sale rules. IRC Sec. 453(h) and Sec. 453B.

[iv] Assuming long-term capital gain. IRC Sec. 1(h).

[v] IRC Sec. 1411.

The corporation will be subject to federal income tax at the flat rate of 21%, and to NY income tax at the rate of 7.65%. When the corporation distribute its after-tax proceeds to its shareholders (whether in liquidation of the corporation, in redemption of less than all of the shareholders, or as a dividend), the gain or income recognized by each individual shareholder will be subject to federal income tax of 20%, a federal surtax on net investment income of 3.8%, and NY ‘s “enhanced” personal income tax (say between 6.33% and 10.9%). If a shareholder is a resident of NYC, they also have to consider the City’s 3.876% personal income tax.

[vi] An excessive payment may be recharacterized by the IRS or the courts, who will try to determine its true character using a “substance over form” analysis; for example, as payment for a non-compete. Where the payment was ostensibly made to acquire property, such a recharacterization would convert hoped-for capital gain treatment into ordinary income.

[vii] Many business owners also own the real property on which the business is located. The buyer may want to lease the property from the former shareholder after the sale of the business. This is more likely to be the case if the buyer is a financial buyer (like a private equity firm that still has a few years before it plans to sell its portfolio companies) as opposed to a strategic buyer; the latter is more likely to consolidate locations and operations.

[viii] Of course, where there are several shareholders with varying degrees of involvement in the business, or where only some of them own property used by the business, the buyer in the situations described will necessarily pay them disproportionately to their shareholdings.

[ix] The long-term capital gain rate is applied to so-called “qualified dividend income.” IRC Sec. 1(h)(11). The 3.8 percent surtax will also apply to the dividend. A shareholder’s stock basis will only come into play if the amount of the distribution exceeds the corporation’s current and accumulated earnings and profits. IRC Sec. 301(c)(2), (3).

[x] And in some cases, even when they are not distributed to the shareholders. See, for example, the accumulated earnings tax at IRC Sec. 531.

Too often, a controlling shareholder will withdraw money from a corporation as a loan. Then there are those situations in which all the shareholders receive “loans” in proportion to their stock ownership. Really guys?

Of course, the corporation may not claim a deduction for the loan – it is expected to be repaid; similarly, the receipt of a loan is not taxable to the borrower-shareholder. More often than not, however, the loan is not memorialized in writing (for example, with a note), does not bear interest, is not secured, and does not have a payment schedule or even a maturity date. A risky business, indeed.

[xi] Hopefully through an LLC that is “transparent” for tax purposes.

[xii] IRC Sec. 162; Reg. Sec. 1.162-7.

[xiii] A so-called “disguised” distribution. Of course, dividends may come in many other forms (“constructive” dividends), including the rent-free use of corporate property, or the payment of personal expenses incurred by a shareholder.

[xiv] The typical closely held business.

[xv] This is one of those situations that requires the assistance of an expert. Both Corp and the IRS relied on experts to establish “comparables” against which to measure Shareholder’s compensation.

[xvi] Recall the standard for determining the fair market value of property: what a hypothetical willing buyer would pay a hypothetical willing seller, neither of whom is under any compulsion to buy or sell, and each of whom has knowledge of the relevant facts.

[xvii] Clary Hood, Inc. v. Comm’r, T.C. Memo. 2022-15 (March 2, 2022).

[xviii] I think I could work with this guy. Think Hotspur from Henry IV, of whom Prince Henry says: “he that kills me some six or seven dozen of Scots as a breakfast, washes his hands, and says to his wife, ‘Fie upon this quiet life! I want work.”

[xix] Shareholder personally set the salaries and bonuses for all other officers and personnel on an individual basis.

[xx] The two tax years immediately following the review period.

[xxi] Query what – more likely, who – could have prompted this inquiry.

[xxii] Filed on IRS Form 1120.

[xxiii] IRC Sec. 6212.

[xxiv] IRC Sec. 6213; Tax Court Rule 34.

[xxv] Tax Court Rule 142(a). It would behoove a taxpayer to never forget this – the record has to be set contemporaneously with the transaction in question, not after the IRS has identified the transaction as one in which it is interested.

[xxvi] IRC Sec. 11(a), 61(a), 63(a).

[xxvii] IRC Sec. 162(a)(1); Reg Sec. 1.162-7(a), 1.162-9.

[xxviii] Reg. Sec. 1.162-7(b)(3) (providing that reasonable and true compensation is only such an amount “as would ordinarily be paid for like services by like enterprises under like circumstances”).

[xxix] After all, there is an inherent conflict of interest.

[xxx] Reg. Sec. 1.162-7(b)(1).

[xxxi] IRC Sec. 7482(b).

[xxxii] The Court observed that some federal courts have supplemented or hybridized the multifactor approach for analyzing the reasonableness of shareholder-employee compensation with the so-called “independent investor” test.

Under this standard, a court typically asks “whether an inactive, independent investor would be willing to compensate the employee as he was compensated.” If so, there may be a strong inference that the employee provided reasonable compensable services and that corporate profits were not being siphoned out as dividends disguised as salary.

Corp contended that the Court should follow the independent investor test in determining whether the purported compensation paid to Shareholder in the years at issue was reasonable. The Court responded that, while at least one Court of Appeals has found value in this approach, the Court of Appeals to which an appeal would lie has not adopted any iteration of the independent investor test.

Because the Tax Court generally applies the multifactor approach unless a case is appealable to a Court of Appeals which has expressly applied the independent investor test, the Court applied the multifactor approach to determine the reasonableness of Corp’s purported compensation paid to Shareholder. Golsen v. Comm’r, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).

[xxxiii] Neither the Court nor the IRS should substitute their own business judgment, the Court stated, for that of Corp as to setting the appropriate amount of a given employee’s compensation; however, the Court also stated it would examine the extent to which that compensation may be deducted for federal income tax purposes because “limits do exist for what may be reasonably deducted” as compensation.

[xxxiv] Whether by sales, net income, gross receipts, or capital value.

[xxxv] Instead of gross revenue.

[xxxvi] The IRS’s expert witness confirmed this view. He placed Corp’s performance in the upper quartile of its industry peers for the period in which Corp attained its most profitable jobs through the direct involvement of Shareholder.

[xxxvii] According to the Court: “When a person provides both capital and services to an enterprise over an extended period, it is most reasonable to suppose that a reasonable return is being provided for both aspects of the investment, and that a characterization of all fruits of the enterprise as salary is not a true representation of what is happening.”

Corp’s strengthened financial ability to disperse significant sums of cash by the years at issue is evidenced by evidenced by several items, including the actual outlay of cash to Shareholder in the form of purported bonuses during the years at issue.

[xxxviii] Reg. Sec. 1.162-7(b)(3).

[xxxix] The Court noted that it was not bound by the opinion of any expert witness and would accept or reject expert testimony, in whole or in part, in the exercise of its own sound judgment.

[xl] Corp’s justification for Shareholder’s higher compensation for the years at issue included his debt guaranties and surety bond guaranties during the review period, which may qualify as a deductible business expense on its own.

The Court took into account some of the following considerations when deciding the deductibility of such fees paid to a shareholder-employee: (1) whether the fees were reasonable in amount given the financial risks; (2) whether businesses of the same type and size as the payor customarily pay such fees to shareholders; (3) whether the shareholder-employee demanded compensation for the guaranty; (4) whether the payor had sufficient profits to pay a dividend but failed to do so; and (5) whether the purported guaranty fees were proportional to stock ownership.

The record showed that it was customary for the owners of construction companies to guarantee debts and bonds, and that compensation for these guaranties was appropriate. The Court recognized that Shareholder historically did not seek compensation for the guaranties and Corp had sufficient profits to pay a dividend during the years at issue; however, the Court placed more weight on the customary nature and reasonableness of the fees.

[xli] We have all encountered instances where the so-called employee had little involvement in the business. It is one of the fastest ways to lose credibility in an IRS audit.