By Stephen D. Kirkland, CPA, CMC, CFF
Yes, according to some published Tax Court cases, including Choate Construction Company, T.C. Memo. 1997-495.
My report and courtroom testimony highlighted the fact that the founder had worked for minimal pay in the first years of the business. In his published opinion, Judge John Colvin (who later became the Tax Court’s Chief Judge), agreed that catchup pay should be considered when determining reasonable compensation for the services of Millard Choate:
“An employer may deduct compensation paid in a year for services rendered in prior year. Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 [8 AFTR 10901] (1930); R.J. Nicoll Co. v. Commissioner, 59 T.C. at 50-51. Respondent [the IRS] contends that petitioner's pay to Choate in 1992 did not include catch-up pay for 1990 and 1991. We disagree. Choate testified that his compensation for 1992 included catch-up pay for his services to petitioner before 1992. Choate received no pay in his first 6 months working for petitioner. Petitioner underpaid Choate in 1990 and 1991 to keep more cash in the company so that it could obtain surety bonds. Choate awarded himself a large amount of catchup pay in 1992, when petitioner had become successful.”
The court went on to say that catchup compensation can be paid soon after it was earned or more than ten years after it was earned:
“Respondent points out that cases permitting catchup pay because of past under compensation usually involve a substantial base period. See Lucas v. Ox Fibre Brush Co., supra (14 years); R.J. Nicoll Co. v. Commissioner, supra (13 years); Acme Constr. Co. v. Commissioner, T.C. Memo. 1995-6 (7 years); Comtec Systems, Inc. v. Commissioner, T.C. Memo. 1995-4 (12 years). Respondent concludes from this that a deduction for catchup pay is not available in a company's third year. We disagree. If a taxpayer otherwise qualifies, it may deduct catchup pay. The fact that petitioner could provide catchup pay quickly is another measure of Choate's success.”
The court also wrote: "Kirkland's opinion is that reasonable compensation to Choate for 1990, 1991, and 1992 would have been an average of $539,416 per year. Kirkland based this amount in part on Choate's pay from Toon, his prior service to petitioner, the absence of benefits from petitioner, petitioner's return on equity, and Choate's success with petitioner. (Kirkland noted that he found no boats or lakehouses, or relatives on petitioner's payroll, leading him to observe that petitioner is a very "clean" organization.) Choate's pay from petitioner from 1990 to 1992 averaged $456,000. Kirkland said this was reasonable in amount, considering that Toon paid Choate $250,693 in 1983, $312,134 in 1984, $434,148 in 1985, and $460,000 in 1986. Choate's average pay from Toon for 1985 and 1986 was $447,074, slightly more than his 1990-92 average pay from petitioner. This fact tends to show that Choate's pay in 1992 was reasonable."
There is a certain twist to considering an individual’s prior pay levels. On the one hand, someone’s prior pay can suggest what they deserve in a later period. For example, consider someone who was paid $1 million annually in earlier years. It might be assumed that his or her services are also worth $1 million annually now. On the other hand, someone’s earlier pay level might suggest that he or she deserves catchup pay. For example, someone who was paid $50,000 in an earlier year may deserve $1 million of current pay now, plus $950,000 of catchup pay for that earlier year. My point is this: if someone was paid a modest amount in an earlier year, does it suggest that they deserve the same modest amount now? Or does it suggest that they now deserve some catchup pay for that earlier year?
Executive compensation is a complex subject and it requires close examination of the facts and judgment to determine a reasonable amount of pay for any year.