Unreasonable Compensation & The Family Business
June 19, 2017
“Add-Backs”
In the course of valuing a target business, a potential buyer will want to develop an accurate picture of the target’s earnings and cash flow. In doing so, the buyer will try to normalize those earnings by “adding back” various target expenses that the buyer is unlikely to incur in the ordinary course of operating the business after its acquisition. These may include certain one-time costs (for example, an “ordinary and necessary” litigation expense), but the most common add-backs involve payments made to or for the benefit of persons who are somehow related to the owners of the business. Among these related party payments, the compensation paid to family members is by far the most frequently recurring add-back.
“Why is that?” you may ask. Because family-owned and operated businesses are notorious for often paying unreasonable amounts of compensation to family members. These payments may exceed the fair market value of the services actually rendered by the family member – “reasonable compensation,” or the amount that would be paid for like services by like enterprises under like circumstances – or even may be made to a family member who does not actually work in the business. In the case of a family member who is employed by, and provides a valuable service to, the business – a service for which the buyer will have to pay after the acquisition – the add-back will be limited to the amount, if any, by which the payment exceeds reasonable compensation.
There are many reasons why family-owned businesses pay unreasonable compensation: to support a child or grandchild, to enable a family member to participate in retirement and health plans, to make “gifts” to them as part of the owner’s estate planning, and, of course, to zero-out the employer-payor’s taxable income.
Whatever the motivation, the payment violates one of the precepts often advanced by this blog: in a business setting, treat related parties on an arm’s-length basis as much as possible.
“Father Knows Best” (?)
A recent decision of the U.S. Tax Court described one taxpayer who ignored this precept at great cost.
Taxpayer was a C corporation engaged in a wholesale business. Its president and founder (“Dad”), along with his four sons (not My Three Sons; the “Boys”), were its only full-time employees and officers. Each of them performed various and overlapping tasks for the Taxpayer, including tasks that might have been performed by lower level employees. The Boys performed no supervisory functions.
Just before the tax years at issue (the “Period”), Dad owned 98% of Taxpayer’s stock; the other 2% was owned by an unrelated person. Dad then transferred all of his shares of nonvoting common stock to the Boys, after which Dad owned only shares of voting common stock.
Dad was familiar with the marginal income tax rates applicable to him and to his sons. Dad alone determined the compensation payable to the Boys; he did not consult his accountant or anyone else in determining compensation. The only apparent factors considered in determining annual compensation were reduction of Taxpayer’s reported taxable income, equal treatment of each son, and share ownership.
On its corporate income tax returns for the Period, Taxpayer deducted the compensation paid to the Boys.
During those same years, the Taxpayer paid only one insignificant dividend.
Interestingly, during one of the years at issue, Dad considered selling Taxpayer to an unrelated person. They entered into a nondisclosure agreement, and Dad provided the potential buyer with salary figures for the shareholders (his own and the Boys’), adjusted to a market rate that was significantly below what was actually being paid.
Disallowed Deductions
The IRS audited Taxpayer’s returns for the Period, and issued a notice of deficiency in which it disallowed Taxpayer’s deduction for much of the compensation paid to the Boys, claiming that it was unreasonable.
In general, a taxpayer must show that the determinations contained in a notice of deficiency are erroneous, and it specifically bears the burden of proof regarding deductions.
The Tax Court found that Taxpayer’s evidence with respect to the reasonableness of the compensation, as presented by its expert, was not credible.
In fact, the Court was quite critical of the Taxpayer’s “expert.” In most cases, it stated, there is no dispute about the qualifications of the experts. “The problem,” the Court continued, “is created by their willingness to use their résumés and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, which is contrary to their professional obligations.”
The Court concluded that Taxpayer’s expert disregarded objective and relevant facts and did not reach an independent judgment.
“Reasonable” Compensation
The Code allows as a deduction all the ordinary and necessary expenses paid or incurred by a taxpayer 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. A taxpayer is entitled to a deduction for compensation if the payments were reasonable in amount “under all the circumstances,” and were in fact payments purely for services.
Whether the compensation paid by a corporation to a shareholder-employee is reasonable depends on the particular facts and circumstances.
In making this factual determination, courts have considered various factors in assessing the reasonableness of compensation, including:
- employee qualifications;
- the nature, extent, and scope of the employee’s work;
- the size and complexity of the business;
- prevailing general economic conditions;
- the employee’s compensation as a percentage of gross and net income;
- the shareholder-employees’ compensation compared with distributions to shareholders;
- the shareholder-employees’ compensation compared with that paid to non-shareholder-employees;
- prevailing rates of compensation for comparable positions in comparable businesses; and
- comparison of compensation paid to a particular shareholder-employee in previous years where the corporation has a limited number of officers.
No single factor is dispositive. However, special scrutiny is given in situations where a corporation is controlled by the employees to whom the compensation is paid, because there is usually a lack of arm’s-length bargaining.
The Court’s Analysis
The Court noted that while “the actual payment would ordinarily be a good expression of market value in a competitive economy, it does not decisively answer the question” of reasonableness “where the employee controls the company and can benefit by re-labeling as compensation what would otherwise accrue to him as dividends.”
According to the Court, Taxpayer acknowledged as much in the materials prepared in connection with the possible sale, in which the shareholder salaries were recast to a much lower “market rate.”
As in many family enterprises, the Boys were involved early on in the business and did whatever was needed to keep the business going. Compensation in closely-held businesses is subject to close scrutiny because of the family relationships, and it is determined by objective criteria and by comparisons with compensation in other businesses where compensation is determined by negotiation and arm’s-length dealing.
In their testimony, the Boys denied knowledge of principles basic to the performance of their respective functions on behalf of Taxpayer. Moreover, none of them had any special experience or educational background. Each of them testified that they had overlapping duties, but those duties included menial tasks as well as managerial ones because there were no other employees.
Dad testified that he intended to treat the Boys equally, that he alone determined their compensation, and that he was aware of their marginal tax rates, obviously intending to minimize Taxpayer’s, and the family’s overall, tax liability.
The amounts and equivalency of the Boys’ compensation – allegedly to avoid competition among them – the proportionality to their stock interests, the manner in which Dad alone dictated the amounts, the reduction of reported taxable income to minimal amounts, and the admissions in the sale materials relating to their compensation “all justified skepticism,” the Court stated, toward Taxpayer’s “assertions that the amounts claimed on the returns were reasonable.”
The Court was especially critical of Taxpayer’s compensation expert. The expert did not consider any of the foregoing factors. He disregarded sources and criteria that he used in other cases, and that would have resulted in lower indicated reasonable compensation amounts. He used only one source of data although, in his writings and lectures, he had urged others to use various sources. Although he testified that he was an expert in “normalizing owner compensation,” which is “adjusting the numbers to what they think a buyer might experience,” he did not attempt to do so in this case. In attempting to justify the compensation paid to the Boys in the absence of material reported earnings, he assumed that Taxpayer increased in value from year to year.
The expert placed Taxpayer’s officers in the 90th percentile of persons in allegedly comparable positions, which their own testimony showed that they were not. He determined aggregate compensation of the top five senior executives in companies included in his single database while acknowledging that the titles assigned and duties performed by Taxpayer’s officers were not typical of persons holding senior executive offices. He understood that the compensation was set solely by Dad and was not the result of negotiation or arm’s-length dealing, but he ignored that factor. He relied completely on the representations of Dad and the Boys and did not consult any third parties.
Although his report discussed officer retention as a reason for high compensation, he did not consider the likelihood – as confirmed by the Boys’ testimony – that any of them would ever leave Taxpayer’s employ, even if he were paid less.
The approach throughout the appraiser’s report indicated that it was result-oriented – to validate and confirm that the amounts reported on Taxpayer’s returns were reasonable – rather than an independent and objective analysis. The Court found that, overall, neither the expert’s analysis nor his opinion was reliable.
Because Taxpayer’s expert’s opinion disregarded the objective evidence and made unreasonable assumptions, the Court held that Taxpayer failed to satisfy its burden of proving the reasonableness of the amounts paid to the Boys in excess of those allowed in the notice of deficiency.
Apologies to Dad? Nope
Yesterday was Father’s Day, yet here I am, one day later, writing about a Dad who tried to do right by his Boys, but was punished with an increased tax bill. Unfortunately, he deserved it. The compensation paid to the Boys appeared solely related to their shareholdings, to Dad’s desire to transfer his wealth to them equally, and to his desire to reduce the Taxpayer’s corporate income tax liability.
This is what happens when you violate the precept recited above: in a business setting, treat related parties on as close to an arm’s-length basis as possible; stated differently, “you mess with the bull, you get the horns.”
This simple rule accomplishes a number of goals. It supports the separateness of the corporate entity and the protection it affords from personal liability. It rewards those who actually render services, and may incentivize others to follow suit. It may cause those who are not productive to leave the business. It may reduce the potential for intra-family squabbling based on accusations of favoritism. And let’s not forget that it helps to avoid surprises from the IRS.
Where estate and gift planning is a consideration, there are other means of shifting value to one’s beneficiaries. Combined with the appropriate shareholders’ agreement, these transfers may be effectuated without adversely affecting the business.