Because the agency has enjoyed a good deal of success in court on this, taxpayers need to be wary, says Thomas P. Ochsenschlager, a partner in accounting firm Grant Thornton LLP's Tysons Corner, Virginia, office. "If the IRS audits your company and sees anything that looks like excessive compensation, not only will it push hard on the audit, but the agency won't compromise with you," he explains. "It will take you to court because it has been very successful in that venue."
Some business owners often "push the envelope in this area," says Mark Luscombe, principal federal tax analyst for CCH Inc., a Riverwoods, Illinois-based provider of tax and business law information. "The IRS is looking to see whether there is a pattern on a return of low tax and a salary level that fluctuates up and down with the income earned. That's often a tip-off that maybe there's some funny business going on with setting compensation," he explains.
A few recent cases offer several useful insights.Take the case of Olympic Screen Crafts (OSC) & Associates Inc. v. the IRS Commissioner. Owner Allen Blazick opened up this shirt silk-screening company in 1970 for $180. When the business began to grow, Blazick brought in his brother-in-law, Steven Richter. In 1982, Blazick decided to incorporate. He became president and CEO and owned 90 percent of the company. Richter was then named vice president and owned the remaining 10 percent.
By 1991, the company had more than 200 employees and annual gross sales of more than $13 million. Three years after incorporating, Blazick and Richter adopted an incentive compensation plan that was intended to recognize the two for their contributions to the company. The plan stated that payment would be made according to the stock ownership of the two owners.
The two owners were the plan's only participants. Under the formula established by their accountant, nearly all of the company's net income was distributed as incentive payouts to the two owners and deducted as compensation. The business never declared or paid out any dividends.
OSC offers a textbook case of what not to do regarding compensation, says Ochsenschlager. The court found that if the bulk of the corporate earnings are paid out as bonuses, as OSC's were, it's fairly clear that profits are being siphoned out of the company disguised as compensation. Another questionable practice cited by the court was the fact that the company never paid or declared a dividend, even though in 1988 or 1989 the company's accountant advised OSC to pay them. The IRS even presented a credit memorandum prepared by Blazick's bank saying that Blazick had indicated he "does not intend to be taxed twice for the profitability of his business."
The IRS won this one hands down. As a result, the tax agency disallowed a substantial amount of the compensation, saying it represented nondeductible "disguised dividends." The tax court agreed with the finding, as did the U.S. Court of Appeals. In addition to instructing the owners to pay the taxes owed, the company was assessed a penalty for negligence.
In another case, the IRS successfully found that a good portion of the compensation independent contractor Kirk Eberl claimed in 1992 and 1993 also constituted "disguised dividends." Eberl was an independent claims adjuster helping insurance agencies settle claims in areas hit by disasters. In his case, Eberl was being paid a negotiated fee for each claim he handled. In 1992, he took compensation totaling $4.3 million and in 1993 his compensation was just over $2 million.
The court found that Eberl set his own compensation. In addition, he distributed almost all the profits to himself at the end of the year. Therefore, says the court, a substantial portion of his compensation was "a disguised dividend." It ruled that Eberl could take only $2.3 million in 1992 as reasonable compensation and $1 million in 1993. In addition to the payment of additional taxes, he was also hit with a hefty penalty for the two years in question.