Second Circuit rejects Tax Court's analysis of reasonable compensation.

• Author: Barton, Peter C.

In Dexsil Corporation, 6/3/98, the Second Circuit vacated and remanded TC Memo 1995-135, which had partially disallowed Dexsil's compensation deduction for its chief executive officer (CEO) (who was also Dexsil's majority shareholder). The Court of Appeals ordered the Tax Court to reconsider the disallowance of the deduction in light of the factors that determine reasonable compensation for services performed. With the current booming economy, reasonable compensation is an important issue for closely held corporations whose employee-shareholders want to get more money out of the corporation and have it deduct the payments.

Sec. 162(a)(1) allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered." The problem is distinguishing between reasonable compensation (which is deductible) and dividends (which are not), when an employee is also a shareholder and the corporation is closely held. The corporation and the employee-shareholder both want to characterize the corporation's payments as deductible compensation. Moreover, if the employee-shareholder is the majority or sole shareholder, he determines the payment amounts. Therefore, the IRS and the courts scrutinize such payments carefully and disallow any amounts disguised as dividends.

In Elliotts, Inc., 716 F2d 1241 (1983), the Ninth Circuit specified five factors that determine whether compensation is reasonable:

1. The employee's position, hours worked and duties performed;

2. A comparison of the employee's compensation with that paid by similar companies for similar services;

3. The financial condition of the company, as indicated by its sales and net income, and its complexity;

4. Potential conflicts of interest, such as majority shareholder-employees who disguise dividends as salary or receive unduly large bonuses, or both; and

5. Internal consistency in the company's compensation of employees, as evidenced by the use of a reasonable, long-standing, consistently applied contingent compensation formula. Also relevant is the compensation of nonshareholder employees.

No single factor determines if compensation is reasonable; the five factors must be assessed from the perspective of a hypothetical independent investor: Would an independent investor approve the compensation paid to the employee by the company in question, given the dividends received (if any) and the return on equity (ROE) enjoyed by the investor? The independent...