When it comes to paying business owners and key executives, there is always a fine line to walk between what the IRS considers too much, and what is considered adequate compensation for what is often years of hard work.
The problem with the IRS’s reasoning is that it often doesn’t take into account the effort that business owners go to in making their businesses a success, and how much that effort can cost in the early days. What looks like excess on one hand, may not be when averaged out and taking years of losses into account.
This was demonstrated in a recent tax court appeal case, where the IRS was trying to overturn bonuses and parts of a business owner’s salary. In this case, the business owner had built up his business over a 17-year period, spending on average 80+ hours per week working in the business, performing managerial duties, research and development, product, sales, marketing and advertising. For the first 10 years of the business’s life, the taxpayer received nothing for three years in a row and then small salaries ranging up to $47,000 per year. However, when business began to take off, some 13 years after it began, the taxpayer began taking larger bonuses and salaries. For the two years the IRS was objecting to, the taxpayer received $278,000 in salary and a $1 million bonus one year, and a $12,000 salary/$2 million bonus the next.
The business didn’t have a formal remuneration policy, but its corporate records did indicate that the business had agreed to pay the taxpayer something more reasonable for his integral role when the business could afford to do so. (See – yet another reason to keep your corporate records up to date!) The business also began paying bonuses to other key people as it could afford to do so.
When the Tax Court looked at everything, they found almost entirely in favor of the taxpayer. The success the company was now enjoying could be attributed mostly to his efforts, and he had been underpaid for years while the company was developing.
There were five keys the Tax Court looked to when making its decision:
- Role of employee. How important is that employee to the business’s overall success?
- Comparison with other employees in a similar capacity. How much is the competition paying?
- Consideration of the company’s size (as measured by sales, net income and capital value). What was the cash on cash return for shareholders, and the company’s net margin?
- Compensation from the perspective of an independent investor. Given all of the factors, including the compensation paid to key employees, is this still an attractive investment?
- Did the company have a structured compensation plan? Without a plan, bonuses can often be a red flag for management abuse. The court will look for a company’s financial stability and growth when examining this factor.
At the end of the day the Tax Court found that the taxpayer had been the driving force behind the business’s success, and his vision and hard work had led to the increased sales and return on equity for shareholders. The taxpayer had not been overpaid – he had been well compensated for the effort he had put in.