Let’s say that you own 100% of a company. Let’s say your company is quite profitable, and that you take out massive bonuses at year-end. The bonuses serve two purposes: first: why not? You took risk, borrowed money and worked hard. If the thing folded, you would have sunk with it. If it succeeds, why shouldn’t you succeed with it? After all, no politician built it for you. Second, bonuses help reduce taxes the company has to pay. Granted, they increase the taxes the shareholder has to pay, but that is a conversation for another day.
Let’s say the IRS questions the bonus. They think your bonus is unreasonable.
Let’s discuss the Midwest Eye Center case.
Dr. Afzal Ahmad
Dr. Afzal Ahmad was the sole shareholder of Midwest Eye Center (Midwest), a multi-location ophthalmology and eye care center in Chicagoland. This is a pretty large practice, with approximately 50 employees, five surgeons, three optometrists and so on. Dr. Ahmad was doing well, receiving a salary of $30,000 every two weeks. At the end of the year he would also draw a sizeable bonus, which coincidently reduced corporate taxable income to zero. In 2007 he took a bonus of $2,000,000.
There were reasons for the bonus. One of his busier surgeons quit unexpectedly in June, 2007. That surgeon was generating approximately $750,000 in revenues, and Dr. Ahmad took over the additional patients. Then there was another doctor who was reducing her workload as she established her own practice. Dr Ahmad starting absorbing some of these patients too.
Busy year for the doctor.
One more fact: Midwest filed taxes as a C corporation, which means it paid its own taxes.
The IRS came in and disallowed $1,000,000 of the bonus. Why $1,000,000 exactly? Who knows, except that (1) it is an impressive amount, and (2) it is close enough for government work.
As Midwest was a professional services corporation, its tax rate was the maximum, so there immediately was additional tax of $340,000. The IRS also assessed penalties of over $62,000.
This was a nice audit for the IRS: limited issues and big bucks.
So how did the tax advisor defend Midwest?
There is standard text that any tax practitioner (at least, one who follows tax cases) has read a thousand times:
“Deductions are a matter of legislative grace and are allowed only as specifically provided by statute.”
Basically the tax Code says that everything is taxable and nothing is deductible – unless the Code says otherwise. IRC Section 162 allows us to deduct “reasonable and necessary expenses.” So far, so good. Salaries have to be deductible, right? Hold up. The Code says that a “reasonable allowance for salaries or other compensation” is deductible.
We have to show the “reasonableness” of the salary.
The first way is to show that an “independent investor” would have paid the salary. Midwest decided not to use this line of defense, as no dividends were paid and no profits were left in the company. You have to leave some crumbs on the plate so the investor does not starve. Granted, Warren Buffett does not pay dividends, but he always leaves profit in Berkshire Hathaway.
OBSERVATION: The lack of dividends does not have to be fatal, but it does complicate the argument. For example, if I owned an NFL team, I might be willing to operate it at a loss. The value of my team (if I were to sell it) would likely be increasing more than enough to offset that operating loss.
The next way is by comparison to other businesses. Think professional athletes. If a team is willing to pay the salary, the player must then be worth it. Therefore if someone somewhere with your job duties has a similar salary, there is a prima facie argument that your salary is reasonable. This is more difficult to do with closely-helds than publicly-tradeds, as closely-helds do not tend to publish profitability data.
A third way involves profit-sharing and other incentive plans, hopefully written down and providing formulas should certain thresholds be met. It is important to establish the plan ahead of time and to be certain there is some rhyme or reason to the calculations. Examples include:
- Documenting the doctor’s activities over the years, putting a value to it and keeping a running tally of how compensation is still due. This can be done to “reimburse” the shareholder for those start-up years when the money was not there to properly compensate the shareholder, for example.
- Setting up a bonus formula and following it from year-to-year. If there isn’t enough cash to pay out the amount generated by the formula, then the business would accrue it as “compensation payable.” It is not deductible until paid, but it does indicate that there is a compensation plan in place.
- Having an independent Board of Directors, who in turn decide the amount of compensation. This can be done on an annual basis, preferably earlier rather than later in the year. This technique is not often seen in practice.
- Valuing the company on a regular basis (perhaps as frequently as annually). The intent is to attribute the increase in the value of the business to the shareholder’s efforts. The business would then share some of that increase via a bonus.
So what did Midwest do?
They did nothing, that’s what they did.
And I am at a loss. Midwest had a professional tax preparer, but when push came to shove the preparer provided the Court … nothing.
On to the penalty. The IRS will reverse a penalty if the taxpayer can show that he/she relied upon professional advice. The insurance companies go apoplectic, but it is common (enough) practice for a CPA to fall on the sword to get the client out of a penalty.
But Midwest’s tax preparer was nowhere to be found.
The IRS won on all fronts.
My corporate clients have overwhelmingly shifted to S corporations over the years. S corporations have their own tax issues, but reasonable compensation is not one of them. It is rare for a tax practitioner to recommend a C corporation nowadays, unless that practitioner works with Fortune 500 companies.
Midwest is an example why. It is a second pocketbook for the IRS to pick.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.