Reasonable compensation for closely held corporations.

• Author: Grush, Gary

Excess compensation was the issue in three recent court cases. The facts of the cases were similar; in each, the fact that the principal shareholder was clearly the driving force behind the decisions helps facilitate an understanding of the critical factors that made a difference.

In O.S. C. & Associates, Inc. (OSC), 9th Cir, 8/16/99, aff'g TC Memo 1997-300, the court determined that substantially all the compensation paid to each of two shareholders was a nondeductible, disguised dividend. In contrast, in Richard P. Ashare, TC Memo 1999-282, substantially all distributed earnings were considered deductible compensation. Finally, in Eberl's Claim Service, Inc., TC Memo 1999-211, the court took a middle ground and characterized a portion of the compensation as nondeductible dividends and a portion as deductible compensation.

OSC

In the OSC case, Allen Blazick and his spouse operated a silk screening business. Mr. Blazick, a 90% shareholder, was president and chief operating officer; Steve Richter was the vice president and held the remaining 10% of the shares.

OSC is a textbook example of how not to set up a bonus plan. The company adopted an incentive compensation plan that covered only its two shareholders. Under the plan, the two shareholders would be compensated in direct proportion to their stock ownership. The amount of compensation was determined based on the business exceeding certain hypothetical gross margins that had the effect of distributing virtually all of the company's net income.

The company never paid or declared dividends, even though the company's accountant advised it. Further, a written memorandum explained that the company did not want to pay dividends, because the shareholders did not want the earnings to be taxed twice.

The Ninth Circuit upheld the Tax Court's determination that the "bonuses" paid to the shareholders represented nondeductible disguised dividends. The court focused on a two-prong test referred to in Elliotts Inc., 716 F2d 1241 (9th Cir. 1983), in which the amount of compensation had to be reasonable and the payments had to have a compensatory intent. Under Elliott, it was suggested that reasonable compensation could not be deducted if there was no compensatory intent.

In OSC, the majority decided that the incentive bonus plan was primarily designed to avoid income taxes and, therefore, failed the compensatory intent test. The court based its decision on the fact that most of its net income was...