Fourth Circuit affirms Tax Court’s denial of reasonable compensation deduction

The Fourth Circuit Court of Appeals recently affirmed the Tax Court’s application of the multifactor test in its denial of bonus deductions for a closely held company’s CEO. In the case, the Tax Court held that a portion of compensation paid by a C corporation to its CEO and sole shareholder was unreasonable compensation under Section 162(a)(1).

The reasonable compensation issue is critical for C corporations for determining whether payments are deductible as compensation and incur only one layer of tax as compensation at the individual level, or should be considered distributions that are not deductible against corporate tax and are taxed as dividends again at the individual level.

The Tax Court had originally determined that in the Fourth Circuit — the circuit under which an appeal of the case would lie — eight main factors generally are 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 Tax Court also considered two additional factors that other circuits have considered in the context of small corporations with a limited number of officers (like the company in this case):

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

Many of the circuits have established different standards for assessing reasonable compensation, and the taxpayer argued that the court should consider the Seventh Circuit’s independent investors test. The Fourth Circuit held that, while the Seventh Circuit’s independent investor test might be reasonable to consider, along with other factors relevant to the totality of the circumstances, solely using that test “to establish a presumption of reasonableness, as the company urged, would be too narrow” in light of the “what is reasonable under all the circumstances” regulatory standard. Holding that the Tax Court did not err, the Fourth Circuit further opined that the multifactor test, by contrast, “allows for consideration of the numerous other relevant factors” listed above.