Corporate Tax Hike on the Horizon: Using Reasonable Compensation to Withdraw Value

March 09, 2021

Corporate Rate Increase? 

We begin this week with the Senate having passed the President’s $1.9 trillion coronavirus relief and economic stimulus plan (the “American Rescue Plan”[i]) following a marathon session during which Senate Democrats tried to address the concerns of centrists within their own party,[ii] but without alienating more progressive members of the party in both the Senate and the House. Now the revised bill heads back to the House, before being sent to the White House for Mr. Biden’s signature.[iii]

Following this legislative victory, the Democrat-controlled Congress is expected to turn its attention to the President’s multi-trillion[iv] dollar infrastructure (“Build Back Better”) plan, the details of which have not yet been released,[v] but which are expected to include certain tax increases, including corporate tax hikes.[vi]

Speaking of which, a corporation’s taxable income is currently subject to Federal income tax at a flat rate of 21 percent.[vii] During the Presidential race, Mr. Biden proposed increasing that rate to 28 percent – the midway point between today’s tax rate and the top graduated rate of 35 percent[viii] that was in effect before 2018.[ix]

The business profits of a C corporation, or of any other corporation that may be subject to a corporate-level income tax,[x] are subject to income tax twice: once to the corporation, and again upon the distribution by the corporation of its after-tax profits to its shareholders in the form of a dividend.[xi] Under current law, with a 23.8 percent[xii] tax rate for qualified dividends paid by a C corporation to an individual shareholder, the combined effective rate to the corporation and shareholder is 39.8 percent. If the corporate rate were increased to 28 percent, and the dividend rate remained unchanged, the combined effective rate would be 45.14 percent.

Corporate Response?

Other things being equal, an increase in a business’s tax liabilities will cause a reduction in the return on its capital; stated differently, the corporation’s shareholders will enjoy a lower return on their investment in the business.

How, then, does a C corporation respond to increased taxes?[xiii] If it does nothing at all, then its shareholders will bear the brunt of the tax liability – that’s not option that any shareholder would accept, let alone voluntarily select; the corporation may try to pass the increased cost to its customers[xiv]; it may try to cut costs – after all, taxes are another cost of doing business[xv]; the corporation may try to reduce its taxable income.

One means by which corporations have historically tried to reduce taxable income, and also avoid the double taxation of corporate profits, is by foregoing the distribution of non-deductible, after-tax dividends and, instead, transferring such profits to its individual shareholders by means of deductible payments, such as rent for the use of property owned by a shareholder, or as compensation for services rendered by the shareholder.[xvi]

Provided these transactions represent bona fide business arrangements, the corporation will be permitted to deduct the amounts paid to the shareholder,[xvii] acting (for example) as landlord or as service provider, in determining its taxable income, and it will thereby succeed in avoiding corporate-level tax with respect to the amount paid.

Of course, the amount thus paid by the corporation to the individual shareholder will be taxable to the shareholder as ordinary income.[xviii]

Taxpayer’s Payments for “Services”

A recent decision by the U.S. Tax Court explored the factors that a corporation will have to consider if it hopes to support its tax treatment of a payment to an individual shareholder as something other than a non-deductible dividend.[xix]

Taxpayer was a subchapter C corporation for Federal income tax purposes. Most of its revenue came from contracts with government entities for which it had to submit bids.

Taxpayer had three shareholders: Corp (owning 40% of the issued and outstanding shares of Taxpayer’s stock), Ltd (also 40%), and Individual (owning 20%).

Taxpayer did not declare or distribute any dividends to any of its shareholders during the years in issue or in any prior years.


Individual served as Taxpayer’s president and was responsible for its day-to-day management. His responsibilities included project oversight, identifying and bidding on projects, equipment decisions, and personnel matters. Individual also served on Taxpayer’s board of directors. He had decades of experience working for Taxpayer. Individual did not receive written performance reviews from the board of directors. He did not keep records of hours worked.

Individual’s compensation for a year consisted of a base salary, plus a bonus which was paid out of a bonus pool that was based on Taxpayer’s profitability for such year. Individual also received “management fees,” which were set annually by Taxpayer’s board of directors. Additionally, he received director’s fees for his service on the board.

Corp and Ltd

Corp was a holding corporation with no operations or employees. Corp’s president spent five to ten hours helping Taxpayer with a single bid project each year.

Ltd was a C corporation for Federal tax purposes. Its president was not an officer or employee of Taxpayer, though he made himself available to Individual for advice on Taxpayer’s business matters. He also monitored and managed Taxpayer’s investment account; he took a buy-and-hold approach to investing in mutual funds, and did not actively trade funds. He did not track his time spent on Taxpayer-related matters.

Setting the Compensation

Taxpayer did not enter into any written management or consulting services agreements with any of its three shareholders. No management fee rate or billing structure was negotiated or agreed to between the shareholders and Taxpayer for any of the years in issue. None of the shareholders billed or invoiced Taxpayer for any services provided.

Rather, Taxpayer’s board of directors would approve the management fees to be paid to the shareholders at a board meeting held later in the tax year, when the board had a better idea of how Taxpayer was going to perform that year and of how much earnings Taxpayer should retain.

The board did not attempt to value or quantify any of the services performed by Corp or Ltd but, instead, approved a lump-sum management fee for each shareholder for each year. The management fees paid to each entity were always equal each year, even though the services provided by either entity might vary from year to year.[xx]

Moreover, the fees paid to Individual did not represent payment for any particular service provided; rather, the board approved Individual’s management fees as an additional reward beyond what he received through the bonus pool.

Ordinary, Necessary, Reasonable

Taxpayer filed IRS Form 1120, U.S. Corporation Income Tax Return, for each of the tax years in issue, on which it claimed deductions for the above-described payments to its shareholders.

The IRS disallowed these deductions (thereby increasing Taxpayer’s taxable income), and issued a notice of deficiency, which Taxpayer protested by filing a petition with the Tax Court.[xxi]

The Court explained that a C corporation is subject to Federal income tax on its taxable income, which is determined by deducting all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on its business, including a reasonable allowance for compensation for personal services actually rendered.[xxii]

An expense is “ordinary,” the Court continued, if it is customary or usual within a particular type of business or industry, or if it relates to a transaction “of common or frequent occurrence in the type of business involved.” An expense is “necessary” if it is appropriate and helpful for the development of the business. Whether an expense is ordinary and necessary is generally a question of fact.

In determining whether compensation is deductible, the Court next considered whether Taxpayer’s payments were “in fact payments purely for services.” This was also a question of fact to be determined from all the facts and circumstances. The Court explained that distributions to shareholders disguised as compensation were not deductible; stated differently, any amount paid in the form of compensation, but not in fact as consideration for services, was not deductible. In determining whether the compensation paid to a corporation’s shareholders is, instead, a distribution of profit, all the facts and circumstances have to be considered.

Thus, an ostensible salary paid by a corporation may actually be a distribution of a dividend on the corporation’s stock. This is most likely to occur, the Court stated, in the case of a corporation having few shareholders, practically all of whom draw salaries. If, in such a case, the salaries are in excess of those ordinarily paid for similar services, and the excessive payments correspond to, or bear a close relationship to, the stockholdings of the shareholder-employees, it would seem likely that the salaries were not paid wholly for services rendered; rather, the excessive portion of each payment constituted a distribution of earnings upon the stock.

The Court explained that compensation paid by a corporation (especially one that was closely held) to its shareholders would be closely scrutinized to ensure the payments were not disguised distributions. Moreover, where the corporation was controlled by the very employees to whom the compensation was paid, the Court continued, special scrutiny would be given to such compensation in the absence of arm’s-length bargaining.

In order to be deductible, the amount allowed as compensation for services may not exceed what is reasonable under all the circumstances.[xxiii] Generally speaking, “reasonable compensation” is only such an amount as would ordinarily be paid for like services by like enterprises under like circumstances. The reasonableness of the amount paid is a question of fact to be determined from the record in each case. Finally, the test of reasonableness is not applied to the shareholders as a group, but rather to each shareholder’s compensation in light of the individual services performed.

Taxpayer’s Situation

The Court observed that most of the evidence indicated that Taxpayer paid the management fees to its three shareholders as disguised distributions.

Taxpayer made no distributions to its three shareholders but paid management fees each year. According to the Court, this indicated a lack of compensatory purpose.[xxiv] Although the management fees were not exactly pro rata among the three shareholders, Corp and Ltd always received equal amounts despite the different and varying services they provided to Taxpayer each year. This indicated that the management fees were determined on the basis of Corp’s and Ltd’s equal ownership interests, and not on a good faith valuation of the services they provided. In addition, the percentages of management fees that all three shareholders received roughly corresponded to their respective ownership interests in Taxpayer. This finding further supported an inference that Taxpayer paid management fees to Individual, Corp and Ltd as distributions of profits.[xxv]

Also, Taxpayer paid management fees as lump sums at the end of the tax year, rather than throughout the year as the services were performed, even though many services were performed throughout, or early in, the tax year. This practice indicated a lack of compensatory purpose. Another indication that the management fees were disguised distributions of nondeductible profits to the shareholders was the fact that Taxpayer had relatively little taxable income after deducting the management fees.[xxvi] It was not a stretch, the Court stated, to infer that Taxpayer was using management fee payments to lower its taxable income while getting cash to its three shareholders.

Lastly, Taxpayer’s process of setting management fees was unstructured and had little, if any, relation to the services performed. The fees for services were not set in advance of the services’ being provided. Taxpayer did not attempt to value the individual services attributable to the management fees paid to Corp and Ltd, and Individual conceded that his management fees were not paid for any specific services he performed beyond his duties as Taxpayer’s president. This unstructured process for setting management fees indicated that Taxpayer paid management fees as a way to distribute earnings to its shareholders, and not to compensate them for services rendered.

The numerous indicia of disguised distributions, described above, showed that the management fees paid to the three shareholders were not “in fact payments purely for services.”

Reasonable Compensation

At this point, the Court sought to determine whether any portion of the payments made to the shareholders was ordinary, necessary, and reasonable compensation for services. The Court observed that: the parties did nothing to document a service relationship between Taxpayer and either Corp or Ltd; there were no written management services agreements outlining what services were to be performed; no evidence – documentary or otherwise – outlined the cost or value of any particular service; neither corporate shareholder sent invoices for services rendered.[xxvii]

Additionally, Taxpayer presented no evidence showing how management fee amounts were determined, how much any particular service cost, or what portion of each management fee paid to either Corp or Ltd was attributable to any given service.

Reasonable compensation, the Court stated, was only the amount that would ordinarily be paid for like services by like enterprises under like circumstances.[xxviii] Taxpayer presented no evidence concerning what like enterprises would pay for like services. Taxpayer and its shareholders made no attempt to attach dollar values to the individual services provided, let alone demonstrate that like enterprises would pay that amount for such services. Taxpayer failed to introduce any expert testimony to aid in assessing the reasonableness of the amounts paid for the various services. And Taxpayer failed to establish the nature, occurrence, and frequency of most of the services that it argued justified the management fees paid. Neither Corp nor Ltd actually performed any of the “personal services” that Taxpayer argued justified payment of management fees.[xxix] In fact, neither corporate shareholder was in the business of providing management services, or even in a business related to that of Taxpayer’s.[xxx]

Multi-Factor Approach

The Court then turned to whether the management fees paid to Individual reasonable. The Court explained that, in the case of shareholder-employee compensation, the courts have considered the following factors:

  • the employee’s qualification;
  • the nature, extent, and scope of the employee’s work;
  • the size and complexities of the business;
  • a comparison of salaries paid with the gross income and the 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;
  • the taxpayer’s salary policy for all employees; and
  • in the case of small corporations, with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

No single factor is dispositive of the issue; instead, the Court explained, its decision must be based on a careful consideration of the applicable factors in the light of the relevant facts.

Independent Investor

In addition to the above multifactor approach for analyzing shareholder-employee compensation, the Court considered the “independent investor” test, which asks whether an inactive, independent investor would have been willing to pay the amount of disputed shareholder-employee compensation, considering the particular facts of the case.

Court’s Analysis

The Court first applied the multi-factor test. In assessing whether Individual’s management fees were reasonable in amount, the Court indicated that an employee’s superior qualifications may justify higher compensation for his services, as may the employee’s duties performed, hours worked, general importance to the success of the company, and the company’s performance in the context of prevailing general economic conditions.[xxxi]

Perhaps the most significant factor, the Court stated, was a comparison of the Individual’s compensation with prevailing rates of compensation paid to others in similar positions in comparable companies within the same industry. For each taxable year in issue, Individual received a salary, a bonus from an employee bonus pool, and management fees. The Court determined that the management fees Taxpayer paid to Individual were not meant to compensate him for any unique services outside the scope of his responsibilities as president, but instead served essentially as additional bonus compensation.

Without taking into account the management fees, it appeared that Individual was already highly compensated relative to presidents at Taxpayer’s industry peers. Indeed, his average annual salary and bonus exceeded the industry average and median by a substantial margin. Considering only Individual’s salary and bonus, the Court found that Individual was overcompensated during the taxable years at issue. Because the management fees paid to Individual were ostensibly additional compensation for services that he performed as Taxpayer’s president – services for which he was already highly compensated in comparison to peer companies – the entire amount of the management fees paid to Individual appeared unreasonable.

Next, the Court applied the independent investor test. The failure to pay more than a minimal amount of dividends, it observed, may suggest that some of the amount paid as shareholder-employee compensation was a dividend. Of course, a corporation is not required to pay dividends – shareholders may be equally content with the appreciation of their stock. The independent investor test, the Court noted, may be used to assess whether the amount of shareholder compensation was reasonable in the light of the return on equity the corporation’s shareholders received during the same timeframe.

The Court reiterated that Taxpayer never paid dividends. And while Taxpayer argued correctly that it was not required to pay dividends, it did not show that the shareholders received a fair return on account of their shares. Taxpayer did not present evidence or expert testimony regarding what return on equity an independent investor might find reasonable. The IRS, however, provided data and analysis which indicated that Taxpayer’s shareholder compensation scheme did not allow for adequate shareholder returns. The report concluded that Taxpayer’s operating income margins were significantly below those of its industry peers. By paying such high shareholder compensation, Taxpayer was less profitable. Low profitability led to relatively lower retained earnings and, consequently, low returns for the hypothetical independent investor.

In the end, Taxpayer failed to show that a hypothetical independent investor in its stock would have found its investment returns reasonable with the shareholder compensation.

Court’s Conclusion

In sum, Taxpayer failed to carry its burden of proving that the management fees paid to Individual were reasonable. They were not for any services beyond his responsibilities as president, and the IRS provided persuasive evidence that Individual was already overcompensated by his salary and bonus alone.

As indicated above, there were numerous indicia that the management fees paid to Individual were simply disguised distributions; and much of the evidence supported the conclusion that the management fees paid to him were not reasonable.[xxxii]

Finally, Taxpayer never paid dividends to its shareholders and presented no evidence showing that an independent investor would have been satisfied with investment returns after shareholder compensation.

Thus, the Court sustained the IRS’s disallowance of Taxpayer’s claimed deductions for management fees paid to its three shareholders.

What’s Next?

It is likely that the Federal corporate income tax rate will be increased in the not-too-distant future. It is equally likely that closely held C corporations and their shareholders will seek ways to withdraw value or profits from the corporation while mitigating the tax and economic impact of the tax increase.

As discussed above, the payment of reasonable compensation to a shareholder-employee is a viable option, provided it is determined and paid in accordance with the factors indicated. The establishment of a qualified retirement plan is another way to reduce a corporate employer’s tax liability while setting funds aside for the benefit of shareholder-employees and other employees.

If the shareholders own real property out of which the corporation operates, they should enter an arm’s-length lease (if they don’t have one already). The rental payments would be deductible by the corporation; at the same time, the real estate may be generating depreciation deductions that would reduce the shareholder-landlords’ income tax liability attributable to the rental payment.[xxxiii]

Another way for shareholders to access corporate funds is by borrowing from their corporation, especially in a low-interest rate environment. Although the loans made are not deductible by the corporate-lender, neither are they taxed as income to the shareholder-borrower, provided the loans are structured and treated as bona fide loans.[xxxiv]

Most importantly, the corporation and its shareholders should consult their tax advisers on a regular basis to stay on top of tax legislation, including the effective date of any changes, and to ensure they are taking advantage of every income deferral opportunity, every deduction and every credit available.


[i] H.R. 1319.

[ii] Remember, the Democrats couldn’t afford to lose any members in the evenly-divided Senate if they hoped to give Vice President Harris the tie-breaking vote.

[iii] It is expected to pass this week; probably today or tomorrow. The President will be signing the bill no later than this weekend.

[iv] “Trillion” – that’s a “1” with twelve (12) zeroes after it.

So, where does that take us? $2.30 trillion in the March 2020 CARES Act, $0.90 trillion (“billion” is so passé) in the December 2020 Consolidated Appropriations Act, $1.90 trillion in the March 2021 American Rescue Plan; a total of $5.0 trillion within a 12-month period.

[v] You may recall that, in early February, the Associated Press wrote that Mr. Biden was tentatively scheduled to appear before Congress on February 23, 2021 to give an “unofficial” State of the Union address, by which time, it was hoped, the American Rescue Plan would have been well on its way to enactment. Various other publications indicated that the President intended to use the occasion to unveil a large infrastructure package, including tax increases. Then, one week before the joint session, AXIOS reported that the White House press secretary had informed reporters that no such address was scheduled. Go figure.

[vi] Late last month, Treasury Secretary Yellen stated that the Administration was considering increased corporate taxes to help fund its infrastructure plan, which would be set in motion later this year – probably before the summer recess.

[vii] IRC Sec. 11, as amended by the Tax Cuts and Jobs Act of 2017. P.L. 115-97.

[viii] Which was among the highest in the world.

[ix] Query, given where interest rates are today, whether deficit spending is preferable? Or is it just a means of deferring more difficult decisions; basically, taking the easy way out so as to avoid offending, or incurring the wrath of, any constituents? If government were a business, the latter approach would eventually end in its dissolution.

[x] For example, an S corporation that is subject to the built-in gains tax under IRC Sec. 1374.

[xi] The so-called “double taxation” to which the profits of a C corporation are subject.

C corporations may try to delay or avoid making a dividend distribution so as to defer or avoid the shareholder-level tax. However, see the accumulated earnings tax at IRC Sec. 531 to 537.

[xii] The 20 percent income tax under IRC Sec. 1(h), and the 3.8% surtax on net investment income under IRC Sec. 1411.

It should be noted that, during the campaign, Mr. Biden also proposed to increase the income tax rate on dividends paid to certain high-income taxpayers from 20 percent to the rate applicable to ordinary income (which is currently 37 percent, but which Mr. Biden would increase to 39.6 percent). https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ .

Ms. Yellen has indicated that increased rates for capital gains are on the table. At the same time, she has stated that tax increases may not be appropriate during a recession. Thus, as the economy improves, the likelihood of such a rate hike increases.

[xiii] There are twice as many studies out there as there are answers to this question: one study that supports a particular answer, and another that refutes it.

[xiv] There are practical limits to this approach, like driving customers away, to less expensive competitors.

[xv] That’s why (before the enactment of the GILTI rules in 2017) U.S. corporations sought to defer U.S. tax by keeping the profits earned by foreign subsidiaries overseas. That’s why businesses leave New York and California for jurisdictions with lower taxes and lower labor costs.

[xvi] Similar efforts are often made upon the sale of a C corporation’s assets. The shareholders will seek a way to by-pass the corporation and direct consideration to the shareholders themselves; for example, through the sale of personal goodwill, or through the leasing of personally-owned property. The IRS is well attuned to identifying such gambits.

[xvii] IRC Sec. 162.

[xviii] Currently set at a Federal rate of 37 percent; Mr. Biden has proposed an increase to 39.6 percent.

[xix] ASPRO, Inc. v. Comm’r, T.C. Memo. 2021-8.

[xx] According to the Court, nothing in the record explained the fluctuation in management fees paid to each entity.

[xxi] The taxpayer generally bears the burden of proving that the IRS’s determinations in a notice of deficiency are erroneous. Tax Court Rule 142(a). The Code requires the taxpayer to maintain records sufficient to establish the amount of any deduction claimed. IRC Sec. 6001.

[xxii] IRC Sec. 162(a)(1); Reg. Sec. 1.162-7(a).

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

[xxiv] “[T]he absence of dividends to stockholders out of available profits justifies an inference that some of the purported compensation really represented a distribution of profits as dividends.”

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

[xxvi] Without deducting the management fees Taxpayer would have had taxable income; the fees eliminated 89%, 86%, and 77% of what would have been Taxpayer’s taxable income for the taxable years at issue.

[xxvii] Unlike the two corporate shareholders, Individual was an employee of Taxpayer, providing personal services on an ongoing basis. Thus, there was no reason to question whether it was ordinary or necessary for Taxpayer to compensate Individual. But the total compensation still had to be reasonable.

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

[xxix] The Court could not identify any “personal services” performed by Ltd or Corp, and Taxpayer did not establish what amounts of the management fees paid to each shareholder were to compensate for these “services” and whether such amounts would have been paid by like enterprises under like circumstances.

[xxx] Taxpayer did not establish that it was customary or usual for a business like Taxpayer’s to pay for advice. Taxpayer did not establish what amount this service should cost or that like enterprises would pay an amount for advice like this.

[xxxi] This “factor helps to determine whether the success of a business is attributable to general economic conditions, as opposed to the efforts and business acumen of the employee.”

[xxxii] The same conclusion applied equally to the management fees paid to the two corporate shareholders, not just Individual.

[xxxiii] Don’t forget to consider the effect of IRC Sec. 267(a)(2): https://www.law.cornell.edu/uscode/text/26/267 .

[xxxiv] For example, they should bear interest at a rate that is at least equal to the applicable federal rate; preferably, the interest should be payable currently. The loan should be documented accordingly, with board minutes authorizing the loan and a promissory note issued by the shareholder.

And don’t overlook the opportunity to use corporate loans creatively; for example, to acquire life insurance as part of a split-dollar arrangement. Reg. Sec. 1.7872-15.