Federal tax policy and practice

Employee Compensation Deduction

Tax Research Memorandum

Mr. Jones, President

From: Tax Accountant, CPA

Tax Treatment of Employee Compensation in Business Deductions

Facts

Mr. Jones is the President of a corporation owned by him and members of his family. Mr. Jones was paid $48,000 in salary and the corporation paid $12,000 in a pension plan contribution on Mr. Jones's behalf for the tax year. The IRS Agent claims that both the salary paid to Mr. Jones and the pension plan contribution must be taken into account to determine whether the total compensation is reasonable in amount. The corporation wants to know if the pension plan contribution must be taken into account in determining the total compensation reasonableness to Mr. Jones.

Issue

The issue is whether the pension plan contribution paid by the corporation must be included with Mr. Jones salary for the tax year to determine whether the total compensation was reasonable under the tax codes.

Rule

The total compensation includes salary and any other compensation for personal services actually rendered. This would include salary, benefits, such as vacation, sick leave, and retirement benefits, stock options, bonuses, and any other benefits the corporation provides for the employee, whether it is personal travel expenses, birthday awards, etc. Brewer Quality Holmes, Inc. v. Commissioner, No. 03-61040, (5th Cir. 2004) adjusted the deduction based on nine factors from Owensby & Kritikos, Inc. v. Comr., T.C. Memo. 2001-262. The nine factors included employee qualifications, nature, extent, and scope of employee's work, size and complexity of the business, comparison of salaries paid with gross and net income, economic conditions, comparison of salaries with distributions to stockholders, rates of compensation for comparable positions with comparable concerns, salary policy as to all employees, and the presumption of correctness. The deduction was adjusted 5% in favor of Brewer Quality Holmes for retirement benefits not being provided to the employee.

Analysis

In the Internal Revenue Code 162 (a)(1), the clause "for salaries or other compensation for personal services actually rendered" forms the basis for law of reasonable compensation. The foundational issues include (1) the intent test (whether payment is in fact made for services rendered) and (2) the amount test (whether the amount of payment is reasonable). Tax courts generally do not consider whether a compensatory purpose (intent) exists unless there is evidence of purported compensation payments exists, although reasonable in amount, were in fact disguised dividends. If there is evidence of disguised dividends, the corporation must separately satisfy the reasonable test and the compensatory intent test.

In Section 1.162-7 (a) it states that included among ordinary and necessary expense paid or incurred in carrying on any trade or business a reasonable allowance for salary and other compensation for personal services actually rendered. The test of deductibility of compensation is whether they are reasonable and are in fact purely for services. The test for (a) may be illustrated as follows: (1) any amount paid in the form of compensation as the purchase price of services, (2) the form or method of fixing compensation is not decisive as to deductibility, and (3) in any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.

When a case involves a closely held corporation with the controlling shareholders setting their own level of compensation as employee, the reasonableness of the compensation is subject to close scrutiny. This deduction was adjusted, Devine Brothers, Inc. v. Commissioner, T.C. Memo. 2003-15, 8135-01 (2003). The burden is on the petitioner to show that it is entitled to a compensation deduction larger than that allowed by the respondent, or Commissioner, Paula Constr. Co. v. Commissioner, 58 T.C. 1055, 1058-1059 (1972).

The reasonableness of compensation is a question of fact to be determined from the record in each case. All facts must be considered with no one factor as determinative, Estate of Wallace v. Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992). The Tax Court's determination of whether compensation paid by a corporation is reasonable is a question of fact that will not be reversed unless it is clearly erroneous, Rutter v. Com'r, 853 F.2d 1267, 1271-72 (5th Cir. 1988).

Most courts are focusing on the nine factors of the Owensby & Kritikos, Inc. v. Comr., T.C. Memo. 2001-262 case. They are as follows:

1) Employee qualifications.

2) The nature, extent, and scope of the employee's work.

3) The size and complexity of the business.

4) The comparison of salaries paid with gross income and net income.

5) The economic conditions of the business.

6) The comparison of salaries with the distribution to stockholders.

7) The rates of compensation for comparable positions with comparable concerns

8) The salary policy as to all employees.

9) The presumption of correctness.

It is also clear that the total compensation includes salary and other compensation that is provided by the corporation in the compensation of the services that are actually rendered by the employee. These include salary, bonuses, benefits (vacation, sick leave, maternity leave, pensions, personal expenses paid by the corporation (travel, etc.), or any other compensation that is given for the actual services rendered. The reasonableness of the total compensation amount is determined by the nine factors above.

Conclusion

Based on the analysis above, it is clear that the pension plan contribution must be considered with Mr. Jones' salary as part of the total compensation in determining the reasonableness of the compensation being deducted by the corporation. The pension plan contribution would be considered as compensation for services actually rendered by Mr. Jones and would be considered as part of the compensation that includes his salary.