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Compensation or Dividend: Know the Difference

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The U.S. Tax Court recently ruled that payments made to a corporate taxpayer’s three shareholders were dividends — not compensation for personal services rendered. The court’s reasoning also may be relevant in shareholder disputes and divorce cases when the parties disagree about whether compensation should be deducted from earnings when valuing a business interest. (Aspro, Inc. v. Commissioner, T.C. Memo 2021-8, Jan. 21, 2021.)

Background

Under current tax law, a corporation may deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services rendered. In the case of compensation payments, a test of deductibility is whether they’re in fact payments purely for services.

On the other hand, distributions to shareholders disguised as compensation aren’t deductible for federal income tax purposes. Specifically, Internal Revenue Code Section 162 says:

Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur 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 or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.

Case Facts

The taxpayer operated as an asphalt paving business. Most of its revenue came from contracts with government entities. These public projects are awarded to the low bidder.
Aspro has three owners:

  • Shareholder A is an individual who owned 20% of the company,
  • Shareholder B is a corporation that owned 40% of the company, and
  • Shareholder C is a corporation that owned 40% of the company.

Shareholder A also served as the company’s president and was responsible for its day-to-day management. His responsibilities included bidding on projects. Shareholder A often spoke to the individuals who owned corporate shareholders B and C to get their advice on bidding for projects.

In 2014, Aspro paid management fees to its shareholders for their advisory services on how to bid for projects. Aspro then deducted these management fees for personal services rendered. Neither in 2014 nor in any prior year did Aspro pay dividends to its shareholders. The IRS denied the deduction, claiming the fees were actually dividends.

Tax Court Decision

The Tax Court agreed with the IRS. It didn’t dispute that a portion of payments made to Shareholder A potentially might have been compensation for personal services. However, since the payments weren’t purely compensation, they weren’t deductible for federal income tax purposes.

Factors underlying the court’s decision to classify the payments as dividends, not a form of compensation, include:

Lack of historical dividend payments. Aspro is a corporation with few shareholders that never distributed any dividends during its entire corporate history; it merely paid management fees.

Payments corresponding to ownership percentages. The management fees weren’t exactly pro rata among the three shareholders. However, the two corporate shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests.

Payments to shareholders, not individuals. Aspro paid the amounts to corporate shareholders B and C, instead of to the individuals who actually performed the advisory services.

Timing. Aspro paid management fees as lump sums at yearend, rather than paying them throughout the year as the services were performed.

Lessons Learned

The appropriate treatment of payments to shareholders should be decided on a case-by-case basis. The decision has implications beyond federal income taxes. To the extent that a company’s value is based on its earnings or net free cash flow — say, under the income or market approaches — the deductibility of these payments can have a major impact on the value of a business interest.

The federal income tax rules for how to treat these expenses can provide objective guidance when classifying payments for other purposes. In some cases, it may be appropriate to adjust a company’s earnings for deductions that represent dividends, based on the facts of the case.

For more information about the classification of compensation and dividends or other valuation issues, please contact the professionals at Advent Valuation Advisors

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How Reasonable is Your Owners’ Compensation?

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There are many factors to consider when determining reasonable owners’ compensation. Photo by Matthew Henry from Burst

For most privately held businesses, owners’ compensation is one of the largest expenses on the income statement, especially when all the related perks and hidden costs are calculated. Compensation should accurately reflect what others would receive for similar duties in a similar setting. Reasonable compensation levels are important not only for state and federal tax purposes, but also to get an accurate estimate of the fair market value of the business.  

Total Compensation Package

Before compensation can be assessed as reasonable, all components of the package must be calculated, including:

  • Direct salaries, bonuses and commissions,
  • Stock options and contingent payments,
  • Payouts under golden parachute clauses,
  • Shareholder loans with low (or no) interest and other favorable terms,
  • Company-owned or leased vehicles and vehicle allowances,
  • Moving and relocation expenses,
  • Subsidized housing and educational reimbursements,
  • Excessive life insurance or disability payments, and
  • Other perks, such as cafeteria plans, athletic club dues, vacations and discounted services or products.

In addition, owners’ compensation may be buried in such accounts as management and consulting fees, rent expense and noncompete covenants.

IRS Guidance

The IRS has published a guide titled, “Reasonable Compensation: Job Aid for IRS Professionals.” IRS field agents use this guide when conducting audits to help determine what’s reasonable and how to estimate an owner’s total compensation package.

The IRS is on the lookout for C corporations that pay employee-shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t.

Owner-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay owners’ salaries to minimize state and federal payroll taxes. Rather than pay salaries, S corps are more likely to pay distributions to owners. That’s because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.

The IRS job aid lists several sources of objective data that can be used to support compensation levels, including:

  • General industry surveys by Standard Industry Code (SIC) or North American Industry Classification Systems (NAICS),
  • Salary surveys published by trade groups or industry analysts,
  • Proxy statements and annual reports of public companies, and
  • Private company compensation reports such as data published by Willis Towers Watson, Dun & Bradstreet, the Risk Management Association or the Economic Research Institute.

“Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances,” states the IRS job aid.

Compensation Benchmarks

Beyond IRS audits, the issue of reasonable compensation may become an issue in shareholder disputes, marital dissolutions and other litigation matters. When valuing a business for these purposes, a company’s income statement may need to be adjusted for owners’ compensation that is above or below market rates.

Courts often rely on market data to support owners’ compensation assessments. But it can be a challenge to find comparable companies — and comparable employees within those companies. The five areas that courts consider when evaluating reasonable compensation are:

  1. The individual’s role in the company,
  2. External comparisons of the salary with amounts paid to similar individuals in similar roles,
  3. Character and condition of the company,
  4. Potential conflicts of interest between the individual and the company, and
  5. Internal inconsistency in the way employees are treated within the organization.

Owners can control compensation, and that creates an inherent conflict of interest when estimating what’s reasonable. External comparisons are key to supporting compensation levels. Business valuation experts typically interview owners to get a clearer picture of their experience, duties, knowledge and responsibilities.

Get It Right

For more information about reasonable owners’ compensation, please contact the business valuation professionals at Advent Valuation Advisors. We can help estimate total compensation levels, find objective market data and adjust deductions that are above or below market rates.

Landmark Compensation Case Turns 25

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Photo by Pepi Stojanovski on Unsplash

When is no compensation considered reasonable compensation?

When an officer of a business is an officer in name only. That is one of the key takeaways of Davis v. United States, one of the landmark cases in the canon of compensation law.

This is the 25 anniversary of Davis v. United States, and Paul Hamann and Jack Salewski recently penned a new analysis of the decision. While the case is held out as the only reasonable compensation case the IRS has lost, the authors argue that a nuanced analysis produces a more balanced view of the decision.

Then they offer some practical advice on putting the lessons of Davis to work in assessing your firm’s – or your client’s – compensation.

You can read their analysis on RC Reports’ website: https://rcreports.com/resources/reasonable-compensation-blog/did-the-irs-really-lose-lessons-from-the-davis-case