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Something’s Wrong

Of late, a not insignificant number of the business owners with whom I’ve been working have raised some concern over whether they are financially prepared for the next stage of their lives.

Sales Deferred

These are individuals who have reached a point in their careers at which they should be planning either for a major liquidity event involving the disposition of their business – their most significant asset – to an unrelated party or for the transition of the ownership and management of the business to their successor.

However, rising interest rates, together with the overall economic and political uncertainty in which we find ourselves, have adversely affected the valuation of many potential target companies in the middle market and have tempered the enthusiasm among many prospective buyers for such companies.  

Under these circumstances, some of these business owners have decided to defer the conversion of their illiquid business into cash until market conditions improve.

Succession Uncertain

Even among those owners who are fortunate enough to have identified a close family member who is capable of assuming leadership of the business following the owner’s retirement and is also willing to do so, there are some who are questioning whether they have set aside sufficient funds to carry them through the next stage of their lives after they have stepped back from the business.  

A member of this latter group may find themselves pursuing somewhat inconsistent objectives.

On the one hand, the owner wants to plan for the reduction of their future gross estate, perhaps through the transfer of equity in the business[i] to their successor.

Regardless of how this transfer is to be effectuated, the owner may be under some pressure to act relatively soon: for one thing, the enhanced unified federal estate and gift tax exemption[ii] is scheduled to be reduced by 50 percent in two and a half years unless Congress acts to extend it[iii]; and the 2024 federal elections could very well see the Democrats reacquire control of Congress while maintaining control of the White House. Neither prospect would be welcome news for the business owner who is planning for the disposition of their estate.[iv]

On the other hand, the owner may be concerned about either (i) ensuring that their estate will have the wherewithal to satisfy the owner’s estate tax liability (federal, and perhaps state[v]) within 9 months of their demise,[vi] or (ii) ensuring that the value of their business will represent a large enough portion of their gross estate that their estate tax liability may be paid in installments,[vii] which militates against gifting significant interests in the business to others.  

Now this owner may also be concerned about stepping away from the business too soon – i.e., before they are economically secure enough to do so.

The Problem

In each of the above scenarios, the business owner has too often looked after the forest (their business and family) and neglected some of the trees (especially themselves) from which the forest grew in the first place.[viii]

Thus, over the years, on an aggregate basis, many owners may have undercompensated themselves for their services, for the business’s use of their other property, or even of their creditworthiness[ix], or the owners may have failed to receive from the business a sufficient return on their investment of funds in the business.

While this is understandable in the early stages of a business’s life cycle, the owner’s failure to withdraw reasonable value often continues after the business has matured and become successfully established.

As justification for this state of affairs, owners will sometimes state that they will realize their “pay day” when they sell the business, at which point they will also enjoy the benefit of the tax-favored rates applicable to long term capital gains.

Similarly, others are reluctant to pay themselves what they are “owed” because they have been told that such payments can only be made in “tax inefficient” ways including, for example, as compensation for services, as rent for the use of real property, or as interest for the use of capital.

Some of these individuals will “address” this problem by borrowing from the corporation[x] or by having the corporation make what are essentially personal expenditures on behalf of the owner.[xi]

Thankfully, there is a better and simpler, albeit more taxing, way to withdraw value from one’s business, but before discussing it, let’s consider a recent Court of Appeals decision involving an owner who was concerned about “getting money out of” their business in anticipation of what they described as “a changing of the guard.”[xii]

An Illustration

CEO and Spouse were the only shareholders of Taxpayer, a corporation that was treated as a C corporation for tax purposes. They were also the only members of Taxpayer’s board of directors.

As a result of CEO’s decision to redirect Taxpayer toward a different line of business, corporate revenues and net profits substantially increased, and Taxpayer’s workforce almost doubled, over a relatively short period.

As Taxpayer’s performance improved, CEO’s annual salary and bonus – as determined and set by CEO and Spouse as Taxpayer’s only board members – was increased.  

During the first of the two tax years in question (the “Tax Years”), during which Taxpayer did especially well, Taxpayer’s CFO began an assessment of CEO’s past compensation and concluded that CEO had been undercompensated in prior years.

To determine how much to compensate CEO for the years in question, the CFO sought the advice of Taxpayer’s accountants (the “CPAs”). Although it was not clear to what extent CEO himself participated in this assessment, according to the record CEO acknowledged,

“that he was aware that he needed to start making necessary preparations from an ‘income tax’ perspective in ‘getting money out of’ the company in anticipation of ‘a changing of the guard.’”

After meeting with the CPAs, CFO determined that CEO had been undercompensated for over a decade and that the total amount that would both remedy that past under-compensation and recognize CEO’s service for the Tax Years was $7.1 million.

CFO suggested that Taxpayer pay CEO a $5 million bonus in the first of the Tax Years, some portion of which was to remedy past under-compensation, with the balance of the under-compensation amount to be paid in “future years.”

The CPAs approved this suggestion, concluding that CFO’s proposal was “reasonable.”

Accordingly, at the meeting of Taxpayer’s board of directors, CEO and Spouse approved paying CEO a $5 million bonus, in addition to CEO’s regular salary. The minutes of that meeting explained that the bonus was approved in recognition of CEO’s “many years of sacrificial work done on [Taxpayer’s] behalf.”

The following year, after Taxpayer went through the same process it had applied for determining CEO’s bonus for prior years, CEO and Spouse, as the only board members, again approved a bonus to CEO of $5 million for the second of the Tax Years, again in addition to CEO’s salary.

During each of the Tax Years, Taxpayer deducted the bonus paid as a reasonable business expense.[xiii]

Despite substantial retained earnings and cash, however, Taxpayer did not consider paying any dividends to its two shareholders – i.e., CEO and Spouse. Indeed, Taxpayer had never paid any dividends.

The IRS Disagrees

Following an audit of Taxpayer’s federal income tax returns, the IRS issued a notice of deficiency for the Tax Years, finding that a substantial portion of CEO’s compensation was excessive and, therefore, not deductible as reasonable compensation for services rendered.[xiv]

As a result, the IRS found that Taxpayer had underpaid its income taxes for the Tax Years, and Taxpayer petitioned the U.S. Tax Court for a redetermination of the asserted tax deficiencies.

Tax Court

During trial, the Tax Court heard from fact witnesses regarding the important role that CEO had played in growing taxpayer’s business and increasing its revenues, as well as the process that Taxpayer followed in determining CEO’s bonuses for the Tax Years. Both Taxpayer and the IRS also presented expert testimony.

IRS Expert

The IRS’s expert agreed that CEO was undercompensated for many years but found that Taxpayer had started to remedy this condition during the years preceding the Tax Years, in which CEO’s compensation was increased.

Based on survey data of compensation paid to other similarly situated executives, the specific characteristics of Taxpayer, and CEO’s contributions, the IRS’s expert concluded that CEO was undercompensated in total by approximately $2.3 million. Taking this under-compensation amount into account, the IRS expert concluded that the total reasonable compensation amounts for CEO should have been just over $5 million for the two Tax Years, and that any amounts above that figure constituted excess or “unreasonable” compensation.

The Tax Court accepted the IRS expert’s calculations[xv] and, thus, found that the amounts deductible as reasonable compensation to CEO for his services during the Tax Years aggregated to just over $5 million.

The Tax Court found that Taxpayer was liable for an income tax deficiency for each of the Tax Years, and Taxpayer appealed the Tax Court’s decision to the Fourth Circuit Court of Appeals.

The Fourth Circuit

The Court explained that the Code allows a taxpayer to 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 personal services actually rendered.”[xvi]

According to IRS regulations, in order to be deductible as an ordinary business expense, compensation “may not exceed what is reasonable under all the circumstances,” taking into account “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”[xvii] And any bonuses paid similarly must not exceed what is reasonable for the services rendered in order to be deductible as an ordinary business expense.[xviii]       

Close Scrutiny

The Court then averred that, in cases that involve “a closely held corporation whose controlling shareholders set their own level of compensation, the reasonableness of the compensation paid to the shareholder-employee is subject to close scrutiny.”

This scrutiny is warranted, the Court continued, because such corporations may more readily choose to pay out larger salaries and bonuses, which are generally deductible by the corporation for its own tax purposes, rather than pay dividends from profits, which are not deductible.

Thus, if some portion of the ostensible salary or bonus paid to a shareholder-employee is in fact a disguised dividend, rather than compensation for services rendered, it is not deductible.[xix]

For these reasons, the close scrutiny to which closely held corporations are subject should focus, the Court stated, on whether bonuses paid to shareholder-employees are compensation only for services actually rendered – which would make the payment deductible – or are the corporation’s effort to transfer profits – i.e., dividends – to the shareholder-employees, which would not be deductible and, therefore, would not reduce the corporation’s income tax liability.

What is Reasonable

To make this determination, the Court applied a standard of reasonableness “under all the circumstances,” taking into account practices and payments “by like enterprises under like circumstances.”[xx]

This, the Court concluded, calls for application of “a multifactor approach that assesses the reasonableness of compensation under the totality of the circumstances.” Under the multifactor approach, no single factor is decisive, but rather one considers numerous factors, such as:

“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; and the salary policy of the taxpayer as to all employees.”

The Court added that, in the context of small corporations that have a limited number of officers, additional factors may be considered, such as the amount of compensation paid to the shareholder-employee in previous years, and whether the shareholder personally guaranteed debts or other obligations of the corporation.

Independent Investor

The Court also found appropriate the suggestion of some other courts of appeal that the various relevant factors may be reviewed through the “lens” of, or “from the perspective of,” a hypothetical independent investor by asking “whether [such an] investor would be willing to compensate the employee as he was compensated.”

Taxpayer contended that the Court should consider the adoption of a singular “independent investor” test, which establishes a rebuttable presumption that an executive’s compensation is reasonable if the corporation’s shareholders are receiving a sufficiently high rate of return on their equity investment. Taxpayer reasoned that under that test the Court should approve CEO’s bonuses because Taxpayer returned 22 percent and 36 percent on equity for its shareholders during the two Tax Years, respectively, after accounting for CEO’s total compensation.  

The Court rejected Taxpayer’s suggestion, stating that the test would be too narrow in light of the regulatory demand that the Court consider “what is reasonable under all the circumstances.”[xxi] The Court noted that, under the independent investor test, an executive’s compensation could be presumed to be reasonable even if it exceeded the amount that was genuinely compensation “for personal services actually rendered,” and that “would ordinarily be paid for like services by like enterprises under like circumstances.” By contrast, the multifactor test allows for consideration of numerous other relevant factors. Accordingly, the Court concluded the multifactor test was the appropriate test to apply.  

Taxpayer asserted that the Tax Court did not adequately account for the return on equity generated for Taxpayer’s shareholders; that it did not appropriately credit CEO’s extraordinary performance and recognize that such performance could justify compensation in excess of the norm; and that it placed too much emphasis on the comparison of CEO’s compensation with that of similarly situated executives in the industry.

The Court, however, observed that these arguments merely raised questions regarding the weight to assign these factors, as the Tax Court considered them among the many factors it addressed in reaching its decision.[xxii] 

Back Pay is OK

The Court observed that the Tax Court had recognized it was permissible for Taxpayer to compensate CEO for under-compensation in prior years; as the Tax Court stated, “[a] taxpayer making such a claim must show: (1) the insufficiency of the officer’s compensation in the previous year[s]; and (2) the amount of the current year’s compensation that was intended as compensation for that underpayment.”

Thus, the Tax Court agreed with CEO that he was entitled to some degree of additional compensation for the services rendered in prior years during which he was under-compensated.

But, focusing in large part on comparative compensation paid by relevant enterprises, as required by regulation, the Tax Court did not agree that a $5 million bonus was appropriate for either of the Tax Years. In reaching that conclusion, the Tax Court pointed to several relevant factors that indicated overpayment, with which the Circuit Court agreed.

Absence of Dividends

First, the court noted that Taxpayer had never declared or paid a cash dividend to its shareholders, even after it began to accumulate significant capital during the period preceding and including the Tax Years.

The Court stated that, although companies are not required to pay dividends, a court may nonetheless consider a profitable corporation’s failure to do so in determining the reasonableness of compensation paid to its shareholder-employees.

In this case, the Tax Court agreed that Taxpayer had advanced persuasive reasons for not declaring dividends for many years during which its business was slow and capital needs were high. It also recognized that Taxpayer’s business was capital-intensive.

But the court noted that this rationale became less persuasive in later years given that Taxpayer’s year-end shareholder equity value had increased nearly sixfold by the time of the Tax Years. Yet Taxpayer opted to pay out large bonuses to CEO rather than paying any dividends.

And the lack of dividends became especially suspect in light of CEO’s testimony that he was aware that he needed to start making preparations from an “income tax” perspective for “getting money out of [the] corporation” in preparation for “a changing of the guard.”

The Tax Court also noted that Taxpayer had “no structured system in place” for determining compensation and that CEO’s compensation was set by CEO and Spouse. “Bonuses that have not been awarded under a structured, formal, consistently applied program generally are suspect . . .” and when “paid to controlling shareholders are open to question if, when compared to salaries paid non-owner management, they indicate that the level of compensation is a function of ownership, not corporate management responsibility.”

Thus, the Tax Court’s suspicion was enhanced by the fact that in the Tax Years CEO’s compensation represented almost 90 percent of the total compensation that Taxpayer paid to its officers, despite the fact that other non-shareholder officers worked similar hours and shared similar responsibilities. While some of that discrepancy could have been attributed to the need to remedy CEO’s past under-compensation, it was nonetheless glaring that Taxpayer’s other officers each received a relatively small bonus for the Tax Years while CEO received a bonus of $5 million for each year.

Finally, the Tax Court placed considerable weight on the comparison of CEO’s compensation with that paid to similarly situated executives in comparable companies. The court stated that, while no single factor is decisive under the multifactor test, such comparisons have been described as “a most significant factor.”

Relying on survey data included in the IRS expert’s report about comparably sized companies in the same business as Taxpayer, and their compensation of employee-shareholders, the Tax Court noted that for the years in question, the IRS’s expert treated CEO as meriting compensation in the 99th percentile based on the company’s success and still found that the compensation actually paid to CEO exceeded what was reasonable. Instead, relying on this comparative data, the expert calculated that reasonable compensation for CEO would amount to less than what he was paid. The Tax Court found these calculations to be “the most credible and complete source of data, analyses, and conclusions.”

The Circuit’s Decision 

At bottom, the Tax Court held that a reasonable total compensation for CEO was the amount determined by the IRS expert, and that the $5 million bonus paid for each year – on top of his salary – was excessive.

With that, the Court affirmed the Tax Court’s decision, finding that Taxpayer did not demonstrate that the Tax Court’s factual findings were clearly erroneous or that the court’s reliance on the IRS report was inappropriate.

Lessons?

Do onto yourself as you would have others do onto you, or some variation thereof?

If someone renders a service to a business, they expect to be paid a fair wage in exchange – nothing more and nothing less.  

If someone leases or licenses property to a business, they expect to receive a market rental or royalty payment in exchange.

If someone acquires stock in a business, they expect to receive dividend distributions when the business does well.

If someone makes a loan to a business, . . . You get the picture. These “truths” are self-evident. Yet it is not at all unusual for the owners of a closely held business to choose to ignore them, usually to the owners’ detriment. By treating with their business at other than an arm’s length basis, the owners expose their returns and those of the business to IRS examination and adjustments, including interest and penalties.[xxiii]

Transact At Arm’s Length

A taxpayer’s return should accurately reflect their income and deductions. When items of income or deduction arise from transactions with an unrelated party, there is a presumption that they clearly reflect the taxpayer’s taxable income from such transactions.[xxiv]

There is no reason why a business owner engaging in “controlled” transactions with their business could not do so on a “tax parity” with an uncontrolled taxpayer. The standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer, thereby ensuring that the results of the controlled transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.

The determination of what constitutes arm’s length dealing may not always be an easy exercise but is it not an impossible task – in fact, in most cases, the determination should be relatively straightforward.

It does require monitoring, but this should be an insignificant nuisance compared to the benefits it will yield for both the owner and the business.

And what about the additional tax cost of higher wages, rents, etc.? For one thing, there should be offsetting deductions in most situations. More importantly, by complying with arm’s length standards, the owners described at the beginning of this post should be in a better economic position than otherwise.

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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] Thereby removing such equity, together with its future appreciation and distributions, from the owner’s gross estate.

[ii] IRC Sec. 2010 and Sec. 2505.

[iii] Not this Congress.

[iv] As we have discussed elsewhere, the experience with the Biden Administration’s Build Back Better plan was a close call. But for two “rogue” Democrats in the Senate – Manchin and Sinema (the former has been somewhat marginalized, while the latter has become an Independent) – the tax world would have changed drastically.

As it is, the Administration has been trying to accomplish through the promulgation of IRS regulations that which it could not do legislatively. That said, the Supreme Court may be overturning the Chevron doctrine shortly, thereby foreclosing much of this regulatory activity.

[v] The combined federal and New York estate tax rate is almost 50 percent.

[vi] The due date for the estate tax. IRC Sec. 6075.

[vii] Over a maximum of 14 years. IRC Sec. 6166.

[viii] I know, the idiom states that one must not lose sight of the forest for the trees, meaning one must not become so immersed in the details of a problem that they fail to see the larger picture of which the problem is just one part. Right?  

Besides, this is my post, so I can try to be poetic or philosophical if I care to.

[ix] When was the last time you saw a business compensate its owner for guaranteeing the debt or other obligations of the business?

[x] We’ve probably discussed this item ad nauseum. How often is the “loan” merely recorded as such on the business’s books, without being evidenced by a written agreement or promissory note, without any formal authorization by the business, without any terms such as a maturity date and an interest rate, and without any payments or collateral?

[xi] The examples are too numerous to mention, but I recently heard, anecdotally, about a construction company that expensed the cost of building a personal residence for its shareholder. (No, I was told the shareholder did not personally bear these costs.) Stupid? Devious? Indifferent? The result is the same.

[xii] Clary Hood, Inc., v. Comm’r; Fourth Circuit No. 22-1573; Appeal from the United States Tax Court. (Tax Ct. No. 3362-19); Decided: May 31, 2023.

[xiii] under 26 U.S.C. § 162(a)(1).

[xiv] It appears that CEO and Spouse’s returns for these years were not examined. Presumably, CEO reported and paid tax on the compensation and bonus, and Taxpayer withheld employment taxes.

[xv] Taxpayer submitted two expert reports, but the Tax Court afforded them “little to no weight” based on the “dubious assumptions” underlying the reports and the lack of supporting calculations.

[xvi] IRC Sec. 162(a).

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

[xviii] Reg. Sec. 1.162-9.

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

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

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

[xxii] As a starting point, the Tax Court recognized the complexity of Taxpayer’s business and acknowledged that CEO was “extraordinarily talented in his industry,” served as the company’s “key employee and driving force from its inception.” The court also acknowledged that the trend of Taxpayer’s increasing revenue “[could] not be credited to economic conditions alone” and that CEO was instrumental in transitioning the business to more profitable projects. The court took account of these factors as well as others in its opinion, allowing reasonable compensation to CEO for his personal services in this regard.

[xxiii] They also may open the way for creditors and other potential claimants to pierce the “corporate veil.”

[xxiv] The same concept forms the basis for the definition of “fair market value”: willing buyer and willing seller (i.e., unrelated), each having reasonable knowledge of the relevant facts, and neither being under compulsion to act.