Category: Compensation & Employee Benefits; Corporations
Subject: Reasonable Compensation
Title: Accumulated Earnings Issue
IRC Sections: 162, 531
Filename: 1050.html
Date Produced: 10/97

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Background
Taxpayer is a C corporation reporting on a fiscal year ending October 31. For its year ended October 31, 1996, the taxpayer had retained earnings of $788,175. No dividends have ever been paid. The IRS assessed the accumulated earnings tax for FYE 10/31/96.

In order to avoid the accumulated earnings tax for subsequent years, the taxpayer's former CPA advised that a corporate T-bill in the amount of $1,350,524 be transferred to the shareholders. The transfer was made on or about August 29, 1997. The corporate minutes characterize the transfer as officer compensation.

To date, the transfer has not been accounted for in the taxpayer's payroll tax returns, and no employment taxes have been deposited with respect to the transfer.

Taxable income for FYE 10/31/97 is $996,000 before consideration of the T-Bill transfer.

You have expressed the following concerns.

· lack of payroll tax reporting at the time of the transfer;
· the fact that the compensation was not put through the payroll checking account;
· the amount characterized as compensation exceeds the amount needed to avoid the accumulated earnings tax problem; and
· the possibility of the transfer being viewed as a dividend.

Observations and Suggestions
The taxpayer transferred $1.35 million to the shareholder on August 29, 1997. That is an unavoidable fact with a strong supporting paper trail--bank records, brokerage statements, 1099-B's, etc. In addition, there is existing documentation in the form of Board of Directors minutes characterizing the transfer as compensation.

You asked me to search for court cases with comparable facts. Not surprisingly, I found none. As we discussed, the nature of this problem is inherently factual, and the fact pattern is extremely unusual to say the least. Absent guidance from the courts, the taxpayer is essentially on his own.

The taxpayer could simply choose to allow the present characterization to stand, amend the September 30 payroll tax returns, and pay any penalties associated with failure to make proper payroll tax deposits. Given the magnitude of the compensation involved, however, I suspect the under-deposit penalties would be significant. In addition, treating the whole transfer as compensation would create a possibly insurmountable problem from a reasonable compensation point of view.

In the alternative, I suggest treating the whole transfer as a loan to the shareholder for the period August 29, 1997 through October 31, 1997. I strongly suggest executing an interest-bearing note to reflect the loan.

I also think it is essential to have the entire loan plus accrued interest paid off on or before October 31, 1997. I think it would be wise to avoid the necessity of reflecting any part this transaction on the year-end balance sheet.

What to do about the existing Board minutes?

I assume the taxpayer feels the existing minutes are simply incorrect and do not reflect the intent of the Directors. Depending on how you and your client feel about this from an ethical standpoint, I suggest either of the following:

A) totally get rid of the original minutes and replace them with minutes that characterize the transfer as a loan followed by a bonus on October 31, 1997; or

B) have another Board meeting resolving that the prior characterization of the transfer was simply inaccurate and stating the true intentions of the Board.

Note that in the event the existing Board minutes are left in place, the IRS could take the position that the original action should be left intact and the subsequent Board action (declaring a bonus in an amount significantly less than the entire $1.35 million) is simply a partial rescission of the original action followed by a refund of the rescinded compensation amount. In that case, there is authority to the effect that the rescission and refund would not give rise to a reduction in the taxpayer's withholding responsibilities. Revenue Ruling 71-289, 1971-2 CB 339, speaks explicitly to this issue and holds that payment of wages results in liability for withholding taxes on the full amount of those wages even if a portion is later returned to the employer voluntarily. Accordingly, if the IRS did take the position that the original transfer should be treated as compensation, the taxpayer would likely be liable for employment taxes based on the full amount of the original transfer.

Regarding the reasonable compensation issue, I offer the following thoughts.

As I understand it, the shareholder-employee founded this business some 14 years ago and has worked in the business on a full time basis continually since its inception. I further understand that the shareholder has drawn a salary of about $50,000 to $60,000 per year.

When the reasonableness of compensation is at issue, it is clear that both prior as well as current compensation can be considered. Hence, if it can be shown that the employee has been under-compensated in prior years, it is much easier to justify what might otherwise be an unreasonable amount of compensation in a single year.

Based on the totality of the taxpayer's facts, is it possible that a strong case might be made that the shareholder's responsibilities and contribution to the success of the business are worth no less than say $125,000 per year? After all, such a figure is not a large amount of money for single-handedly running an entire company. If that figure is indeed reasonable, then the shareholder has been under-compensated by at least $65,000 per year for a period of 14 years. Viewed in this light, compensation in the range of $900,000 to $950,000 does not seem so unreasonable, at least to me.

I previously suggested that the compensation in question be divided between salary, bonus, and nonqualified deferred compensation. I think it would be significantly to the taxpayer's advantage to have a substantial portion of the total compensation characterized as nonqualified deferred compensation. First, deferred compensation is by definition related to the past. Second, deferred compensation is reported not on the officer's compensation line but rather on line 24 or line 25 where it is much less conspicuous.

I suggest that the Board declare additional salary in an amount sufficient to increase the base salary to the $125,000 level (or whatever annual level of salary you think is supportable). In addition, I suggest a bonus in light of the employee's role in arranging the sale that produced all the income in the current year. Perhaps $150,000 of $200,000 would be a reasonable figure in light of the amount of income generated by the sale. I suggest that the remainder to reach the desired net income level be treated as nonqualified deferred compensation.

Clearly, the Board minutes implementing any such decisions should be carefully crafted with reasonable compensation issues in mind. I would be happy to assist with drafting or reviewing the minutes if you so desire.

I understand that one adviser has suggested that total compensation should not exceed approximately $700,000 due to reasonable compensation concerns. Apparently, this adviser feels that the taxpayer should claim no more than can ultimately be justified. I do not have sufficient facts to make a judgment about how much compensation could ultimately be supported. In light of my admittedly very superficial analysis of under-compensation in prior years, however, I wonder if the $700,000 is really the top of what could be justified. More importantly, what does the taxpayer have to lose by claiming compensation in the full amount needed, approximately $950,000? Why volunteer corporate tax on roughly $250,000 of income? I very much disagree with the philosophy of claiming only $700,000. Why not set aside an amount of money equal to the additional tax and interest that would be due if $250,000 of compensation were recharacterized as a dividend. Put this money in a certificate of deposit and keep it there until it is either needed to pay the IRS or the statute expires on the tax year in question.

I look forward to discussing these ideas at your convenience.