Articles

Shareholder Disputes at Closely-Held Businesses

Over the last twenty years, an increasing number of attorneys have contacted me about litigation among shareholders of closely-held businesses.

Shareholders of closely-held businesses in various parts of the United States are embroiled in litigation with each other over the amount of compensation that one or more of the shareholder-officers received.

These lawsuits seem to be increasingly common at professional service firms, including law firms, medical practices and CPA firms. These disputes have also become common in both old economy and new economy businesses.  The older businesses may have been passed along to the second or third generations of the founders’ families. The new economy companies involve e-commerce or intellectual property that has become valuable and the creators feel that they deserve compensation for work they did in the development stages.

In many of these cases, some of the shareholders may not have been aware of the compensation terms between their companies and the officers. Perhaps those terms were unwritten or the officers were able to set their own bonus amounts.  Once other shareholders find out how much the officers were paid, they are often compelled to bring legal action against the officers, even though those officers may be their siblings, cousins or long-time friends.

One of my professors used to say that there are no friends when it comes to money, and these cases illustrate what he meant.

This type of litigation quickly consumes considerable resources, including time and money. Customers and employees who are not directly involved in the disputes can also be affected.

By analyzing the officers' qualifications, duties and accomplishments, I try to reach consensus by determining fair and reasonable compensation amounts for the officers. With some explaining, this may lead to a resolution of the matter.

Or, if given the opportunity early enough, we may be able to help prevent these disputes. To do so, we would need to clearly outline the duties and expectations of each officer, much the same way these companies may do with non-owner employees.  Each officer could be given goals with the potential for performance bonuses when the goals have been reached.  The idea is to create a win-win for all shareholders and all officers.  Get good results for the business - get a bonus.  Yet all too often these arrangements are not thought out, or agreed upon, in advance.  And when they are not, the business may become a "disruptor"...and not in a good way.

Preventing a Challenge to (Un)Reasonable Compensation

© 2013 American Institute of CPAs - All Rights Reserved.
Reprinted with permission from the September 2013 issue of Journal of Accountancy.

►  IRS scrutiny of excessive executive compensation is increasing, affecting many types of taxpayers.  CPAs need to advise their clients on steps they can take to lessen their exposure in this area.

By Stephen D. Kirkland, CPA, CMC, CFC, CFF

As a result of IRS training initiatives, three types of entities draw the most attention and therefore need good advice from CPAs. First, closely held C corporations are examined to determine whether they have overpaid their shareholder-employees. These corporations are allowed to deduct only “reasonable” compensation paid to shareholder-employees. So, examiners are looking for a disguised dividend, which is corporate profit being treated as compensation. Since a dividend is not deductible, but compensation is, the IRS may treat the portion of the compensation that it considers excessive as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest, and penalties on the deficiency.

Conversely, S corporations are audited to determine whether they have underpaid their shareholder-employees. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions. Since compensation is subject to payroll taxes, but distributions are not, some tax savings can be realized by simply reducing a shareholder’s compensation and increasing his or her distributions. But, like C corporations, S corporations are expected to pay reasonable compensation to their shareholder-employees.

Nonprofit organizations are the IRS’s third area of focus. Because key employees may be able to increase their own pay, these nonprofits are often audited to determine whether they have paid excessive compensation. If the IRS finds that insiders have abused their authority by setting their own compensation at unreasonable levels, it will treat the payment of the unreasonable compensation as an “excess benefit transaction” subject to excise taxes under Sec. 4958. This section imposes a 25% excise tax on the recipient of the unreasonable compensation and, in addition, imposes a 10% excise tax on the organization’s managers who permitted the unreasonable compensation payment. These taxes are applied to the portion of the compensation that exceeds the amount considered reasonable. Note that both excise taxes are imposed on individuals, not the charitable organization. Therefore, CPAs should caution any charitable boards they may serve on, as well as their nonprofit clients, of the potential for personal liability.

Executives are often surprised and feel personally insulted when an IRS auditor challenges their pay. In response, they may blame their CPA for not warning them. To prevent such frustration, a few simple steps can be followed.

First, CPAs should make sure the appropriate people are aware of this issue. Clients and their board members do not need to become compensation experts, but they should know that this is a major hot point in audits.

To reduce the likelihood of such a challenge and to minimize the damage if one occurs, CPAs should advise clients to carefully document each executive’s qualifications, duties, and key accomplishments. This documentation is extremely helpful when responding to an IRS challenge.

Advise clients to take time to include more than just the most apparent factors when describing an individual’s qualifications. Education and experience are obvious, but one of the most important factors may be professional goodwill, which includes reputation and relationships in the industry. Effective communication skills are another critical leadership talent sometimes left out of documentation.

In making note of duties and accomplishments, clients should consider the importance of intangibles such as strategic decision-making, leadership, and impact on employee morale. If an individual personally guarantees the employer’s debts, a guarantor fee should be separately computed to keep any compensation issue out of the equation.

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Determining Guaranty Fees for Those who Personally Guarantee a Company’s Debts

It is common for business owners to personally guarantee their companies’ debts.  This is a valuable service since many companies could not otherwise obtain financing in the current lending market.  But business owners are already exposed to considerable risk and do not want to assume even more liability.  When they do, the value of their guaranty should be reflected in their compensation.  (Imagine for a moment how much you would want to be paid if the owner asked you to provide that guarantee.)  In some situations, a fair guaranty fee may be as little as 1% of the amount guaranteed, or as much as 10% of the amount guaranteed.

If no separate guaranty fee is paid, the guarantor’s compensation should be increased to include an appropriate amount for this service.

In one situation, an owner’s compensation was increased because the owner had personally guaranteed some of the company’s debt which had no collateral.  By having his personal guaranty, the company had gotten a much lower interest rate from the lender than it would have otherwise.  The company increased the owner’s compensation by half the amount of interest that the company had saved by having the owner’s personal guaranty.  However, it is usually not that simple since most lenders will no longer even consider an unguaranteed loan if the company does not have enough hard assets or receivables to offer as collateral.

The courts have addressed the value of a personal guaranty, and acknowledged it as a valuable service.  Yet there is not a well-established, one-and-only method of computing the amounts.  Each situation must be considered individually with whatever reliable information is available.  Certainly determining a guaranty fee requires careful consideration of both the amount of the exposure and the risk.  A starting point may be to compare the interest rate to whatever you consider to be a risk-free rate.  Then consider other factors: How important was the debt to the company?  Was the personal guaranty required by the lender?  How many people guaranteed the debt?  Did the guarantor put up collateral, such as his or her residence?  Did the guarantor have the ability to pay, if necessary?  Is there another alternative to the personal guaranty?

Which Types of Compensation are Considered?

The reference in § 162(a)(1) to “other compensation” includes all current and deferred compensation.

Deferred compensation includes employer contributions to qualified retirement plans and non-qualified deferred compensation arrangements.  The current value of any equity-based compensation, such as stock options, is also considered.  The costs of welfare benefits and fringe benefits are also included in total compensation for this purpose.

Therefore, the total value of all cash and non-cash “compensation” (whether or not currently taxable) must be taken into account in determining reasonable compensation.

However, for welfare and fringe benefits, the focus is generally on whether the benefits are comparable to those provided by similar companies to similar employees, rather than the actual cost or value.  If the benefits are comparable, then their cost and value may not need to be determined.  On the other hand, when an individual is not provided benefits comparable to that of his or her peers, additional cash compensation may be used instead.  In contested cases, expert witnesses may be expected to help make this determination and to quantify the amount of cash needed to make up for absent benefits.  See Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo 2003-200.

Contingent Compensation

Contingent compensation may be a discretionary bonus or an amount based on a written formula.  Either way, it must meet the same standards of reasonableness and compensatory intent as traditional salary compensation.

To determine whether the amount is reasonable, carefully consider the facts and circumstances which existed at the time the bonus was declared or the formula or contingent arrangement was adopted.  Treasury Regulation § 1.162-7(b)(2) says:

“The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.”

Bonuses for top executives are sometimes based on a percentage of EBITDA or some variation of EBITDA.  Neither the regulations nor the Tax Court have established specific guidelines as to the percentage of EBITDA that may be paid out as reasonable compensation.  In various published cases, amounts as high as 65% have been considered to be reasonable and amounts as low as 20% have been determined to be unreasonable compensation.  The differences are key factors such as the size of the companies, their industries, and the nature and extent of the duties performed by the shareholder-employees.

A contingent compensation formula does not necessarily have to be applied to other (non-owner) employees in order for it to produce reasonable compensation for the CEO.

One factor to be considered is the contingent pay plan’s approval by other directors and/or shareholders.  In Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286, the Tax Court allowed a closely-held payday lender to deduct $37 million when the former CEO exercised a stock option that had been granted with the consent of other shareholders.

Clearly, there is  much to consider for any employer who wants to motivate its executives for their services, and also avoid payment of unreasonable compensation.

The Multi-Factor Approach

Beginning with Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), the courts have developed various factors to consider in determining whether compensation amounts were reasonable.  Some of the key factors are:

·       The employee’s qualifications, including education and training,

·       The nature, extent and scope of the employee’s duties,

·       The amount of compensation paid for similar services by similar businesses

·       The ratio of compensation to gross revenue and to net profits (before salaries and federal income tax)

·       Whether compensation was set by independent directors

·       Correlation between employee’s compensation and his/her stockholdings

·       The corporation’s history of paying or not paying dividends

·       Prevailing economic conditions

·       Whether payments were needed as an inducement to keep the employee at the employer

·       The financial condition of the company after payment of compensation

·       Scarcity of qualified employees

·       Discretionary bonus paid at end of year

One court listed a total of 21 factors.  See Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-89 (1981).

Several of the above factors do not directly address the reasonableness of the compensation amount.  For example, the correlation between an employee’s compensation and his/her stock-holdings does not directly speak to the amount of pay.  In addition, the corporation’s dividend history does not determine whether the compensation amount was reasonable.  Instead, these factors may help determine the company’s intent when the payments were made.  Was a payment intended to be compensation for services rendered or was it intended to be a distribution of profit?  If year-end bonus payments are in the same ratio as stock holdings, this factor may suggest that the intent was the sharing of profit.

Cases suggest that the factors listed below may indicate that a payment was compensation.

·       Long hours worked

·       Uniqueness of skills/contribution

·       Success in turning the company around

·       Above average growth and/or profitability

·       Extensive experience of the employee

·       High productivity and effectiveness of employee

·       Bonus arrangements/formula entered into prior to becoming a stockholder

·       Employee offered higher salary by other employers

·       Inability of employee to control compensation levels and/or dividends

·       Salary compares favorably with that of similar employees at peer companies

·       Employee was under-compensated in previous years

·       Return on equity is high

Case law suggests that the factors listed below may indicate that a payment was a dividend.

·       Compensation amount exceeds that of peers at comparable companies

·       Lack of dividend payments in prior years

·       Inappropriate compensation formulas

·       Lack of uniqueness of employee’s skills

·       Employee spends little time on the job or works less than in previous years

·       Board of Directors/decision makers are not independent

·       Increase in salary without increase in duties

·       Bonus formulas changed because of high profits

It is important to remember that none of these factors are controlling by themselves.  They do not all carry the same weight.

Every executive and every company is different from others, and that is why many factors need to be carefully considered.  Don’t forget to consider whether the officer is multi-lingual or has other valuable communicating, selling or negotiating skills.  Expertise with technology is valuable in some industries, as is personal or professional goodwill.

Executive compensation can be a complex matter and amounts  are not determined by completing a simple checklist.  Due to the difficulties in assessing these factors, expert witnesses are commonly used in conferences with the IRS Appeals Office and at Tax Court to help determine whether unreasonable compensation was paid.

Using Comparability Data

We often need to determine reasonable compensation amounts for executives, attorneys, charity managers, trustees, or retirement plan service providers.  This is an important process and should not be taken lightly. 

At first blush, it is tempting to assume that the market establishes reasonableness.  Hence, we often use benchmarking, which involves comparing one person’s pay level to amounts paid by other companies. 

Surveys or collections of actual compensation amounts are known as comparability data.  The idea is that, “If similar companies paid their CEOs $x, then that amount must be reasonable for our CEO.”  This is a way of letting the market decide what is reasonable.  Here are some words of caution, however.

It is always interesting to see what others have been paid, but we should not be too quick to draw conclusions.  First, let’s ask whether all incumbents provided the same value.  Carefully consider these questions:  Do all doctors provide the same service?  Do all attorneys provide their clients the same value?  Do all consultants perform the same work?  And do all executives do the same tasks and accomplish the same results? 

The point is – be careful when benchmarking.  Do not be too simplistic in the approach and don’t make careless assumptions. 

Of course, it would be great if we could get some exact matches.  This would mean finding similar-sized companies in the same industry and the same geographic area that had a similar growth rate and comparable profitability, and where the individuals being benchmarked had the same duties and performed at the same level.  Finding exact matches is usually not possible.  Therefore, we often use surveys or compilations of amounts paid by companies in the same or similar industries. 

Below are a few examples of sources of compensation comparability data, although the fact that they are listed here should not be considered to be an endorsement.  Each has its own strengths and weaknesses, and none of them are a perfect fit for every situation.

Publicly-traded companies file financial information with the United States Securities and Exchange Commission (SEC.gov).  The SEC then publishes some of that information, including total compensation amounts for each company’s top officers, on its EDGAR database (Electronic Data Gathering, Analysis and Retrieval).  The Summary Compensation Table shows compensation by person, by year and by type.  The data goes back for years.  Compensation amounts available through EDGAR can be helpful in certain situations, although publicly-traded companies tend to be much larger, more diversified and have more layers of management than closely-held companies.

The United States Department of Labor’s Bureau of Labor Statistics gathers and publishes wage data on its website: www.bls.gov/ncs  (NCS = National Compensation Survey).  The data is available by state.  In addition, the DOL's Occupational Employment Statistics (OES) program produces employment and wage estimates annually for over 800 occupations.  These estimates are available for the nation as a whole, for individual states, and for metropolitan and nonmetropolitan areas.  National occupational estimates for specific industries are also available at www.bls.gov/oesIn addition, the Department of Labor’s Employment and Training Administration sponsors America’s Career InfoNet at www.acinet.orgThis website offers free salary information by zip code or state for 800+ occupations.  Some people who want to consider DOL data find it helpful to use a service that sorts and compiles that data based on their own facts, such as Reasonable Compensation Reports (www.RCreports.com).  

Trade associations often conduct surveys of their members and share the results with their members.  These surveys usually include questions about officer compensation.  Non-members can often purchase these surveys as well, although the price may be higher for non-members. 

GuideStar collects financial data from non-profit organizations and publishes that data on its website (GuideStar.org).  The data comes from annual reports filed by the non-profits with the Internal Revenue Service (IRS Form 990).  Form 990 asks charities for a considerable amount of information about officer compensation, including explanations of how the compensation amounts were determined.

There are also ways to obtain data from multiple sources.  Commercial services obtain large amounts of data from multiple compensation surveys and compile that data into their own databases.  For example, ERI Economic Research Institute (ERIERI.com) conducts their own surveys and purchases other surveys.  They also pull data from EDGAR and GuideStar.  ERI officials have told me that they believe their database to be the most robust collection of compensation amounts available.  Regardless, by using their database, we can draw compensation amounts from many different sources at one time.

Comparability data may also include compensation amounts paid to the same individual in an earlier year.  The theory is: if her services were worth $x in earlier years at a previous employer, then her services must be worth at least $x now.  Prior pay can be especially helpful if it came from a company that the subject employee did not control at the time.  In other words, it is more telling if the prior pay came from a third party and not from a company where the subject had the ability to set his or her own pay level.  But even then, it is usually not that simple.

The Tax Court has examined this issue in several cases, including Choate Construction Company, T.C. Memo. 1997-495.

More words of caution:  When it comes to finding comparability data, try to ensure that the industry data comes from reliable sources and apply careful judgment.

After carefully making market comparisons, you may find that your subject was paid above the average market amounts.  But this may not necessarily mean that he or she received unreasonable compensation.  After all, someone has to be above average, or it’s not an average. 

Rather than focus entirely on paying median or mean market rates, I suggest focusing on some other questions:  Did he or she provide above-average results?  Or below-average results?  Are we getting what we pay for?  Does the value we receive equal or exceed the cost?  Could we somehow get more for our money? 

If an individual is truly unique because of special skills, duties or spectacular results, then his or her compensation may need to be set by means other than comparability data.  Some people are simply off-the-chart.

Please remember that executive compensation is a complex matter.  To be fair, many factors must be considered.  What appears to be unreasonable compensation may not be once all factors are considered.  Rules of thumb can be dangerous.  There is often an answer that is simple, and wrong.  It usually takes expertise, thoughtful analyses and judgment to arrive at reasonable compensation amounts for those with broad ranges of duties.

The Hypothetical Independent Investor Test

In determining reasonable compensation, the courts (and the IRS) have looked to a number of factors and have used various approaches over the years.  Typically, the approach has been to apply from 5 to 12 (or more) factors to determine whether compensation amounts were reasonable.  In recent years, the courts continue to use these factors; however, some courts, beginning with Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), have used the “independent” or “hypothetical” independent investor test as an important, if not prime, consideration in determining whether compensation is reasonable.

Under this test, compensation is, in varying degrees (depending on the court), presumed to be reasonable in amount if an independent investor in the company would still be receiving a reasonable return on his/her investment after the compensation was paid.  If the return was reasonable in light of returns achieved by peer companies, then this suggests that the officer had not drained company profits as disguised compensation.

The independent investor test has been applied in different ways by the courts that have adopted the test.  Calculating the company’s return on equity is a prime consideration.  However, in any version of this test it is always important to determine what the hypothetical independent investor is looking for, i.e., dividends and immediate return or future growth of the company, or both.  See Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 837 (7th Cir. 1999).

Regardless of the degree to which the test is applied, the independent investor test is, at a minimum, an additional consideration to be taken into account in applying the multi-factor approach.  See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5th Cir. 1987).

For example, in evaluating the traditional factors involving the employee’s long hours, experience, effectiveness, and his/her responsibility for the success of the business, an independent investor would pay a higher salary to an employee where the factors were favorable and a lower salary where the factors were not.  The courts that cite Elliotts for reliance on the independent investor test still recite the factors set forth in Elliotts and other cases in their analyses.  See Labelgraphics, Inc. v. Commissioner, 221 F.3d 1091 (9th Cir. 2000).  In fact, the Court of Appeals in Labelgraphics, in upholding the opinion of the Tax Court, stated that “the Tax Court carefully applied the five-factor Elliotts analysis” in relation to what an independent investor would expect.

The 7th and 2nd Circuits have joined the 5th and 9th Circuits in endorsing and enhancing the role of the independent investor test.  See Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999); and Dexsil Corp. v. Commissioner, 147 F.3d 96 (2nd Cir. 1998).  Earlier, the 5th Circuit had indicated its approval of the independent investor test.  See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1327 (5th Cir. 1987).

In Exacto Spring, Judge Posner, writing for the 7th Circuit, adopted the “pure” independent investor test and strongly criticized the use of “factors” in determining reasonable compensation.  He stated that the multi-factor approach leaves “much to be desired -- being, like many other multifactor tests, redundant, incomplete, and unclear.”  Judge Posner went on to say that analyzing the factors test “invites the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts.”

How does Compensatory Intent affect Compensation?

Although the Regulations call for an “intent” test and an “amount” test, the intent test is seldom the primary issue since the corporation’s intent may be shown by how it originally treated the payment.  In the cases where intent has been an issue, the existence or lack of compensatory intent was determined by objective circumstances that occurred contemporaneously with the payment.  For example, courts have considered how the payments were described in board minutes, whether payroll taxes were withheld, whether the payments were included on Form W-2, and whether the payments had originally been recorded as deductible compensation on the companies’ books and tax returns.

One of the leading cases that dealt with intent is Paula Construction Co. v. Commissioner, 58 T.C. 1055 (1972), aff’d without published opinion 474 F.2d 1345 (5th Cir. 1973).  Paula Construction Co. was an S corporation whose S status was inadvertently and retroactively terminated for the years in question.  The principal shareholder-employees, believing the corporation’s S status was still in effect, thought it was unnecessary to claim a deduction for compensation.  Therefore, they did not reflect the corporation’s distributions as compensation in the corporate records or on its tax returns.  The Service denied a deduction for any of the amounts paid since the company did not show compensatory intent when the payments were made.

The Tax Court in Paula Construction stated: “It is now settled law that only if payment is made with the intent to compensate is it deductible as compensation.  Whether such intent has been demonstrated as a factual question is to be decided on the basis of the particular facts and circumstances of the case…”  Id. at 1058-59.

Although the Tax Court acknowledged that the two shareholder-employees had performed valuable and substantial services, it nevertheless held that no compensation was deductible by the corporation on the grounds that “nothing in the records indicates that compensation was either paid or intended to be paid.” Id. at 1059.  This result demonstrates the need to appropriately document all payments to the shareholder-employee in the corporate records.

Compensatory intent has been an important issue when companies claimed that they had paid catch-up pay to make up for earlier years in which shareholder-employees had been underpaid.  Although it is well established that closely-held companies can and do make such catch-up payments, the companies must be prepared to show that those payments were intended to be payment for earlier services.  (Otherwise, the full amount paid in each year is considered to have been paid only for that year’s services.)  Two cases which addressed this issue are E. J. Harrison & Sons, Inc. v. Commissioner, T.C. Memo. 2003-239 and Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo. 2003-200.

Even payments between corporations must have compensatory intent to be deductible as payment for services rendered.  See International Capital Holding Corp. and Subsidiaries v. Commissioner, T.C. Memo. 2002-109.

The way that a corporation treats a payment to its owner is not binding on the Service or the courts.  In other words, a payment is not necessarily going to be recognized as compensation simply because the company recorded it that way.  However, a corporation may find itself being held to the treatment that it originally chose to use in its records when that treatment is disadvantageous to the company.

Can Shareholders Determine Reasonable Compensation for a CEO?

Yes, according to at least one opinion published by the United States Tax Court.

In Allen L. Davis, et al v. Commissioner of Internal Revenue, T.C. Memo 2011-286, the Tax Court considered an unusual set of facts.  Allen Davis and his two adult sons were shareholders of an extremely profitable S corporation.  When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense.

The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis’ sons had agreed to the option grant and they had interests that were adversarial to those of their own father.  (There was strife among the family and there had been litigation amongst them.)

The ruling is distinguished because the court did not rely on the usual multi-factor approach, comparability data or the hypothetical investor test. Instead, Judge Kroupa decided that Mr. Davis’ compensation amount must have been reasonable since the other shareholders had agreed to it when the option was granted.  The opinion states, “The granting of the Allen Option was reasonable because it was not a one-sided bargain.”  In effect, the court relied on the other shareholders to determine whether the compensation was reasonable.

In May 2013, the Eleventh Circuit affirmed the Tax Court’s decision, allowing the company to deduct the $37 million as compensation.

Can Reasonable Compensation for a CEO Include Catchup Pay?

stephen-kirklandBy Stephen D. Kirkland, CPA, CMC, CFC, CFF

Yes, according to some published Tax Court cases, including Choate Construction Company, T.C. Memo. 1997-495.

In his published opinion, Judge John Colvin (who later became the Tax Court’s Chief Judge), allowed catchup pay in 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.”
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Professional and Enterprise Goodwill

An incredible amount of value can be derived from a single idea or a single relationship.

Relationships can be powerful in industries where owners have regular contact with customers, referral sources, suppliers and/or employees. The owners may have many good relationships and have outstanding reputations in their industries.  These relationships and reputations are valuable intangibles that are referred to as professional goodwill.

When determining the value of a business, it is common for valuators to distinguish between professional goodwill, which are assets of the owners, and enterprise goodwill, which are assets of the business. It is wise to also consider professional goodwill when determining the value of the owner’s services.  This may be a reason why reasonable compensation for one person should be toward the high end of the range.

For some businesses, such as professional service firms, it can be especially difficult to separate the professional goodwill from the enterprise goodwill. The relationship between the owner and the business may be so close that they almost seem to be one.  But we must estimate the value of the individual’s services separate and apart from the value of the business enterprise.  And there are various ways to go about this.  For example, David Wood recommended using a point-scoring method to allocate between the two types of goodwill, rather than concluding that all goodwill is professional or all is enterprise (“Goodwill Attributes: Assessing Utility”  by David N. Wood, CPA/ABV, CVA, The Value Examiner, January/February 2007).  Of course, the exact same process may not be best for all situations.  Whatever process we use to distinguish between the two types of goodwill should be well thought out and explained in clear terms.

Does Lack of Dividends Equate to Disguised Dividends?

In analyzing whether a C corporation’s payments to shareholder-employees were compensation or “disguised” dividends, the Internal Revenue Service and courts consider whether dividends were paid by the corporations.

The Regulations say it is “likely” that a compensation payment is in fact a dividend distribution when excessive payments correspond to or bear a close relationship to the recipient’s stockholdings in the company.  Treas. Reg. § 1.162-7(b)(1) and 1.162-8.  On the other hand, the lack of relationship between a recipient’s stockholdings and the proportion of the payment received (compared to other shareholder-employees) has been considered as evidence of compensation.  But neither situation is conclusive.  See Kennedy v. Commissioner, 671 F.2d 167, 175 (6th Cir. 1982). 

The fact that a C corporation paid (or did not pay) a dividend is not solely determinative of whether shareholder-employee compensation was actually a disguised dividend.  The Service does not argue that the lack of dividend payments, irrespective of other factors, must result in a determination of some amount as a disguised dividend.  In Rev. Rul. 79-8, 1979-1 C.B. 92, the IRS said that “deductions for such compensation under section 162(a) of the Code will not be denied on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock.”  The Ninth Circuit rejected the automatic dividend rule in Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1244 (9th Cir. 1983).

However, the IRS often considers a company’s dividend history when selecting companies for audit on the unreasonable compensation issue. Therefore, owners of profitable C corporations should remember that the lack of any dividends may be a “red flag.”  Some companies have, however, successfully rebutted a disguised dividend argument even though they had paid little or no dividends.  They did so by showing legitimate business reasons for paying minimal or no dividends, such as the need for funds for future growth of the business or capital improvements.

How do Stock Options affect Executive Compensation Amounts?

Appreciation in a company’s stock value is one reason that executive compensation amounts appear to be so high.

Publicly-traded companies are required by the Securities and Exchange Commission to publish a table showing how much their top executives were paid the prior year.  Companies usually publish this table in the proxy that is sent to shareholders soon after year end.  The table breaks down compensation by person and by category.

Some readers may notice how high the executives’ compensation amounts were and question why the company spent so much of the shareholders’ money this way.  But readers should realize that the company may not have spent so much money after all.  In fact, most of an executive’s pay may have come in the form of exercised stock options.  The company may have granted options to an executive up to ten years earlier.  Then, the value of the company’s stock increased over a period of years.  Once the executive exercised the options, the appreciation of the underlying stock was reported as part of his or her compensation.  In other words, the pay package may have included amounts that were not cash from the company, but were appreciation in the stock market.

Let’s look at a simplistic example.  A CEO is granted options to acquire 10,000 shares of her employer’s stock.  The stock’s value on the grant date is $10 per share.  That value ($10) becomes the strike price, which means the CEO will have to pay $10 to exercise each option.  Eight years later, the stock value has increased to $50 per share.  The CEO exercises the options and the company issues her 10,000 shares of stock.  Those shares are immediately sold on the market for $500,000.  The company gets $100,000 of the sale proceeds (the strike price).  The CEO gets the other $400,000 of cash and that $400,000 is included in the CEO’s reported compensation.  There are three important points to notice in this example:

1. This $400,000 of compensation was generated by appreciation of the stock, which all of the company’s shareholders would have enjoyed during that time.
2. The company did not pay the CEO in cash.  In fact, the company received $100,000 of cash when the options were exercised.
3. The $400,000 included in the CEO’s pay for the year of exercise was actually from options granted to her eight years earlier.

Some dilution of the stock occurred, however, which would not have occurred if the options had not been exercised.

This is not to say that executives always deserve as much pay as they receive.  Some earn every penny, others do not.  But it is helpful to understand what is in the compensation amounts and where the numbers come from.

Privately-owned companies and non-profit organizations cannot readily offer stock options as part of their compensation packages.  Therefore, to be competitive with publicly-traded corporations, private companies and non-profits may have to offer larger salaries and cash bonuses.

Tax Treatment of Golden Parachutes

The Internal Revenue Code imposes severe consequences on certain golden parachute arrangements.  These plans typically provide for large cash payments to a corporation’s top executives if those individuals are terminated due to a change in the control of the company.

Years ago, these payments were fully tax deductible by the employer if they were “ordinary and necessary” business expenses under Internal Revenue Code section 162.  Due to controversy over large executive pay packages, the Tax Reform Act of 1984 added section 280G to the Code.

General Rules
Section 280G provides that no deduction is allowed for any “excess parachute payment” paid as a result of a change in control of the corporation or a change in the ownership of a substantial portion of its assets (“change of control”).  The payment may be to an employee, independent contractor or other person who performs services for the company and is an officer, shareholder, or highly compensated individual.[i]

In addition to the loss of a deduction for excess parachute payments under section 280G, Code section 4999(a) imposes a 20% excise tax on the recipient of an excess parachute payment.  Since an excess parachute payment would be taxed as ordinary income, the total tax on the recipient may exceed 65%.  This is because he or she must pay federal income tax, Medicare tax, the 20% excise tax and state and local income taxes on that income.

If the payment is made while the individual is still an employee, the employer must withhold the full 20% excise tax.[ii]

Determining an Excess Parachute Payment
The rules for determining an “excess parachute payment” are somewhat complex.  The first step is to determine whether a “parachute payment” even exists.  A parachute payment is defined as any payment in the nature of compensation to an officer, shareholder, or highly compensated individual which is contingent on a change of control, if such payment exceeds a dollar figure equal to three times such person’s “base amount.”  For these purposes, the base amount is an individual’s average annual compensation for the five taxable years ending prior to the year of the change of control.

If a parachute payment exists (the aggregate amounts contingent on a change of control exceed three times the base amount), the excess parachute payment is the entire portion of such payment which exceeds the base amount.

Notice that if the contingent payments exceed three times the base amount, by even one dollar, the entire amount of those contingent payments in excess of the base amount is an excess parachute payment subject to the loss of deduction and the 20% excise tax.

Example
Pam’s average annual compensation for the prior five years was $400,000.  Upon a change of control and her impending termination, she is to receive a parachute payment of $1,250,000.  Since this amount exceeds three times her base (by $50,000), the entire portion in excess of her base amount is an excess parachute payment.  Therefore, $850,000 is non-deductible by the company.  And Pam must pay an excise tax of $170,000 (20% of $850,000).  Note that if the payment to her had been $1,200,000, it would have all been deductible and none would have been subject to the excise tax.

Tips and Traps
Section 280G applies primarily to corporations whose stock is readily tradable on an established securities market.[iii]  Although the golden parachute rules were intended to deal with perceived abuses at publicly-traded companies, these rules can also apply to closely-held companies.  There are exceptions in section 280G(b)(5) which make section 280G apply to non-publicly traded corporations unless the shareholders approve the payment by a super majority vote of more than 75% and there was adequate disclosure to shareholders of all material facts concerning all payments that would otherwise be parachute payments.

Also, note that if an agreement to pay was drafted or modified within a year prior to the change of control, it is presumed to be “contingent on a change of control” unless clearly shown not to be.

In the case of stock options which provide for accelerated vesting upon a change of control, the regulations provide a method for calculating the value of such acceleration.

Payments to or from a qualified retirement plan are not considered to be parachute payments.[iv]  However, any compensatory payment made in violation of securities laws may be treated as a parachute payment.[v]

Code section 280G(e) was added to provide special rules for employers participating in the troubled assets relief program (TARP).

Exception for Services to be Provided
Any amount paid for personal services to be rendered on or after the date of the change in control is not considered to be a parachute payment if the company establishes by “clear and convincing evidence” that the amount is “reasonable compensation.”  There is a similar exception for reasonable compensation paid for services rendered before the change of control.

Summary
There are many potential tax traps to avoid while designing parachute payments.  The IRS regulations under section 280G were written in a question and answer format.  Although these regulations are lengthy, they should be perused carefully before any agreement providing for a parachute payment is finalized or modified.

Executive compensation is both complex and controversial.  And it is especially sensitive and difficult to address after an IRS auditor has arrived and begun an inquiry.  To avoid frustration, embarrassment and monetary penalties, tax and compensation professionals should help educate clients about the risks.  Perhaps more importantly, we should ensure that the amounts paid are not more than the amounts that were actually earned.

[i] Code section 280G(c).
[ii] Code section 4999(c)(1).
[iii] Code section 280G(b)(5)(A).  Note that this is a different definition of publicly-traded company than the one used in section 162(m).
[iv] Code section 280G(b)(6).
[v] Code section 280G(b)(2)(B).

(Un)reasonable Fees Paid by Qualified Retirement Plans

Under Internal Revenue Code section 404(c), which came out of ERISA, each plan sponsor has fiduciary responsibilities to protect the interests of the participants.  Among these responsibilities is an obligation to ensure that fees charged to participants’ accounts are reasonable.  This includes fees charged by investment managers, auditors, attorneys, advisors, and others.

In recent years, high-profile lawsuits were filed against plan sponsors, alleging that these companies allowed unreasonable fees to be charged by investment managers.

A second but related issue involves advisors who recommended certain investment managers and then benefited from revenue-sharing arrangements with those investment managers.

The sponsors’ fiduciary obligations to the participants require that the sponsors always have the participants’ best interests in mind.

On February 3, 2012, the U.S. Department of Labor issued final regulations under Section 408(b)(2) of the U.S. Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  These regulations, which became effective July 1, 2012, require service providers to disclose their fees to the plan sponsor.  Although much of the burden may be on the service providers and not the sponsors, plan sponsors should ask themselves this question: What process do we have in place to ensure that we receive the information that service providers are required to provide us under Section 408(b)(2)?

Also, to avoid common issues which arise during IRS and DOL exams, please be sure your plan documents have been signed (the plan document must be executed for it to be a qualified plan).  Also, the summary plan document must match the terms of the plan.  And please be sure you read the plan documents at least annually to ensure that the terms of the plan are being followed.  These are simple steps but they seem to be overlooked by some sponsors.

Limit on Deductions for Executive Compensation at Public Companies

Section 162(m) of the Internal Revenue Code limits a publicly-held corporation’s tax deduction for compensation paid to a “covered employee” to a maximum of $1,000,000 per year.  A corporation is publicly-held if it has any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934.

A “covered employee” is an individual who is the corporation’s Chief Executive Officer or one of the four highest-compensated officers for the year, other than the CEO.  Officers leaving before the last day of the tax year with no intention of returning are not considered to be covered employees. Compensation paid to these former officers is therefore not subject to the deduction limit of § 162(m).

Certain types of compensation are not subject to the $1,000,000 limit and are not included in the calculation:

(1) Commissions paid “solely on account of income generated directly by the” individual’s performance.

(2) Performance-based compensation paid “solely on account of the attainment of one or more performance goals.”

(3) Contributions to qualified retirement plans.

(4) Tax-excludable employee welfare benefits, such as health insurance.

(5) Certain amounts earned under a pre-1993 written contract. See § 162(m)(4)(D).

Since few senior executives are paid commissions, many companies rely heavily on the exception for performance-based compensation.  To meet this exception, the goals must be approved in advance by a compensation committee of the board of directors.  The committee must include at least two outside directors.  Further, the goals must be disclosed to shareholders and approved in advance by a majority of the shareholders.  The compensation committee must certify that the performance goals were met before the compensation is paid.  The goals must be objective, such as increasing the company’s stock price, market share, sales or earnings-per-share to certain levels.  Simply maintaining the current stock price is enough, but continued employment with the company alone is not enough.

The $1,000,000 limit is reduced by any amount disallowed as a deduction under § 280G, which applies to golden parachute payments.

Stock options and stock appreciation rights are generally not included in compensation for purposes of § 162(m) if they meet the requirements for performance-based compensation.  However, some grants of restricted stock may not qualify for the exclusion, depending upon the circumstances. See Treasury Reg. § 1.162-27(e) which includes numerous examples.

The regulations under § 162(m) are lengthy but should be perused before executive compensation plans are finalized by a publicly-held company.

Please Note
This article provides only a brief overview of a complex subject.  This information is provided only to encourage meaningful discussion and is not intended to be advice for any specific party.  The tax laws change often.  Please seek professional counsel before making any final decisions.  Atlantic Executive Consulting does not provide legal advice or sell any financial products.

Disclaimer

Information on this website is provided for discussion purposes only and should not be construed as advice for any specific situation.  Please seek wise counsel before making decisions.

Atlantic Executive Consulting does not provide legal advice or investment advice.