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RICHARD
M. COLOMBIK
JD, CPA
RICHARD M. COLOMBIK
& ASSOCIATES, P.C.
WHEN IS COMPENSATION
REASONABLE?
A
taxpayer is allowed a deduction for ?a reasonable allowance for salaries
or other compensation for services actually rendered.? IRC §162(A)(1).
The payments for salary are therefore deductible provided, that they
are reasonable and for services rendered.
When
a person is not a shareholder, officer, director or related party, there
is usually no issue as to how much compensation is reasonable.
This is due to the fact that most people would not pay unrelated parties
more money than would be deemed reasonable. Instead, most cases
that address unreasonable compensation arise in the situation of related
parties, sole shareholders or family corporations; e.g., Elliott
vs. Commissioner, 716 F.2d 1241 (9th Cir. 1983).
In
order to determine reasonableness of compensation, courts look at many
factors. The factors reviewed generally are as follows:
Mayson Manufacturing
Co. vs. Commissioner 178 F 2. 115 (6th Cir. 1949).
For
example an employee?s superior qualifications for one?s position
with the business could tend to justify a higher compensation; e.g.,
Home Interiors and Gifts, Inc., vs. Commissioner 73 TC 1142 (1980).
The
analysis becomes more complex when compensation is not for current services,
but is a bonus or compensation paid for past services. This is
because an employer may deduct compensation paid in a current year,
even if it is for performance of services is in a prior year.
Lucas vs. Ox Fibre Brush Co. 281 U.S. 115 (1930). The
court in general terms indicated that a taxpayer must show
how much of current compensation is for past services and the amount
of any past undercompensation. e.g., Estate of Wallace vs. Commissioner,
95 TC 554.
The
reason this issue becomes a litigating vehicle for the Internal Revenue
Service is that a regular corporation, a sub-chapter ?C? corporation,
pays a corporate tax. Payments for compensation, past or current,
are deductible under Internal Revenue Code Section 162. The compensation
deducted reduces the corporation?s current income. Hence, it
reduces the current corporate income tax. If, instead, the government
can disallow payment for current or past services, then the company
does not receive an income tax deduction. The distribution would
be taxed not only at the corporate level as income, but again at the
recipient?s level, usually as a dividend. Therefore, the government
has much to gain, two levels of income taxation by contesting compensation.
The
issue of past compensation arose in Acme Construction Co., Inc. vs.
Commissioner, 1995 TCM 6. In Acme, Mr. David Horth,
after buyouts became the sole family shareholder. During the years
1984 through 1989, David received no greater compensation than $56,000.00
in any one year. This was in spite of the fact that he regularly
worked sixty to seventy hour per week, all year around, and the company
grossed between 3.6 and 5 million dollars. With the exception
of two small loss years, the company?s profitability ranged between
a low $62,000.00 and a high of $603,000.00.
After
the company buyout, David paid himself a bonus for ?past compensation?
of $400,000.00. This was in addition to his base salary.
The government alleged that this was no more than a disguised dividend
and the amount of payment was unreasonable. Therefore, according
to the government?s computation of the total of $442,150.00 paid to
Mr. Horth, only $108,272.00 should be deductible. The government
provided no explanation of how they determined, or their method
of determining the disallowance.
The
tax court reviewed all evidence in the case and found that the petitioner
was undercompensated during many of the years at issue. Further,
due to bonding requirements, banking requirements and other issues,
it was necessary for the petitioner, as well as his brother, to take
undercompensation in order to increase the business? viability.
Since the petitioner, Mr. Horth, was able to establish that he was underpaid
during many of the years at issue, the current compensation for past
services was deemed reasonable and deductible.
Please
note that the IRS argued that one of the methods of proof to establish
past compensation, no formal board resolutions were contained within
the corporate minutes, indicating a lack of corporate formalities. (Note:
Another good reason why taxpayers should always have counsel document
their minute books to determine that corporate formalities have been
followed.) The court ruled in favor of the petitioner and allowed
the deduction based upon the petitioner?s evidence that the payment
was for services rendered.
COLOMBIK?S
LATE BREAKING TAX TIPS
IRS HAMMERED
FOR BEING BIG MOUTH
The
5th Circuit Court of Appeals in Bernard M. Barrett, Jr., vs. United
States, 75 AFTR 2d 95-760, held that the IRS was liable for damages
because of inclusion in a letter of inquiry it sent to a doctor?s
patients indicating the doctor was under criminal investigation.
The inclusion of the statement, sent to third parties, was considered
a wrongful disclosure of tax return information. The IRS argued
that since Dr. Barrett was being investigated by the Criminal Investigation
Division, that it had acted in good faith. The 5th Circuit Court
held that the disclosure was unreasonable, particularly relative to
the fact that no criminal charges were ever brought against the doctor.
The Internal Revenue Service was liable.
MEDICAL EXPENSES
Taxpayers,
at times, have accepted holistic treatment which, many times, the non-traditional
medical issues have been quite helpful. The Internal Revenue Service
has shown not to be as progressive as many medical practitioners though,
in their interpretation of what constitutes a deductible medical expense.
In Nancy Hough vs. Commissioner, 1995 TCM 200, the taxpayer attempted
to deduct traditional medical and dental expenses, as well as non-traditional
expenses including acupuncture, yogi, stress management, vitamin treatment,
and a hot tub. After reviewing the evidence the Internal
Revenue Service concluded that the acupuncture visits did qualify as
deductible medical expense, but that yoga, stress management and vitamins
did not qualify in this case, as deductible medical expense. Further,
the hot tub expenses were actually a home improvement.
Remember
to get your doctor?s written instructions if you need a hot tub, so
that it is a medical hot tub rather than a home improvement. Further,
therapy such as yoga, stress management, vitamins can, in theory, be
deductible again if they are properly prescribed by your health care
professional.
MISSPELLING
EQUALS NO LIEN
In
Gary A. Reid, Jr. vs. IRS, 75 AFTR 2d 95-1904, the U. S. Bankruptcy
Court in the Eastern District of Virginia, held that a misspelling in
an IRS tax lien can be costly. The tax lien at issue was recorded
in the name of Cary A. Reid, Jr. The taxpayer at issue was named
Gary A. Reid, Jr. The Internal Revenue Service held the misspelling
did not affect the lien against property of the taxpayer debtor.
Therefore, the lien was avoidable by the debtor in possession, the bankruptcy
trustee, because reasonable inspection of the index would not reveal
the lien?s existence. Further, the address for Gary A. Reid
was distinctly different from Cary A. Reid?s address. Therefore,
the title examiners that reported the title neither found nor reported
the lien against Cary since the lien was, in fact, filed against Gary.
Thus, the IRS lien was not effective.
Remember,
technicalities can sometimes win the day in tax or bankruptcy proceedings.
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