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.