Tax Court denies reasonable compensation deduction

 

The U.S. Tax Court recently ruled in Clary Hood, Inc. v. Commissioner (No. 3362-19), that a portion of the compensation paid by a C corporation to its CEO and sole shareholder was unreasonable compensation under Section 162(a)(1).

The Tax Court determined that in the Fourth Circuit—the circuit under which an appeal of Clary Hood would lie—eight main factors must be considered when determining reasonable compensation:

  • 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
  • A comparison of salaries with distributions to stockholders
  • The prevailing rates of compensation for comparable positions in comparable concerns
  • The salary policy of the corporation as to all employees


The court also considered two additional factors that other circuits have considered in the context of small corporations with a limited number of officers (like Clary Hood, in this case):

  • Compensation paid in prior years
  • Personal guaranties of debts or other obligations of the corporation


The Tax Court noted that while certain factors favored the corporation, not all factors are afforded equal weight. The court found the following points to be the most relevant and persuasive in concluding that a portion of the compensation paid to the officer/shareholder was not reasonable:

  • Comparable pay by comparable concerns
  • The corporation’s shareholder distribution history (no distributions were ever made)
  • The setting of the officer/shareholder’s compensation (no agreement in place regarding the officer/shareholder’s compensation)
  • The officer/shareholder’s involvement in the business


The court also found the testimony of the IRS’s compensation expert witness to be helpful, as the expert helped consider the multifactor approach—including compensation for the surety bond guaranties—and offered a well-reasoned comparison of the officer/shareholder’s salary against industry standards.

 

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