Tax Court Applies Independent Investor Test to Compensation

• Published date: 01 May 2017
• Date: 01 May 2017
• DOI: http://doi.org/10.1002/jcaf.22265

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© 2017 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22265

Tax Court Applies Independent Investor

Test to Compensation

Shirley Dennis-Escoffier

Twice in the past year the

Tax Court applied the

independent investor test

in considering the issue of

whether compensation paid by

a corporation to shareholder-

employees was reasonable. In

W. H. Johnson, Inc. (TC Memo

2016-95), the Court determined

that the taxpayer satisfied the

independent investor test and

that the entire $11.3 million

paid in compensation was rea-

sonable. However, in Brinks,

Gilson & Lione, P.C. (TC Memo

2016-20), the Court determined

that the investor test was not

satisfied by a personal service

corporation. This case high-

lights the potential cost of

having a large deduction disal-

lowed because the corporation

was also assessed a substantial

understatement penalty. The

Johnson case illustrates the

steps to follow in successfully

defending a deduction for com-

pensation paid to shareholder-

employees, while the Brinks case

points out potential pitfalls.

BACKGROUND

Internal Revenue Code

(IRC) Section 162(a) allows

a deduction for all ordinary

and necessary expenses paid

or incurred in carrying on a

business, including a reason-

able allowance for salaries or

other compensation paid for

personal services. The amount

of compensation that a cor-

poration can deduct is limited

to reasonable compensation

to prevent a corporation from

evading the corporate income

tax by disguising dividends as

compensation because compen-

sation is deductible and divi-

dends are not. Unfortunately,

there is no safe harbor or

bright-line test for determining

whether compensation paid to a

shareholder-employee is reason-

able. Instead, the determination

is based on an analysis of the

facts and circumstances.

Regulation 1.162-7(b)(2)

provides that compensation

paid pursuant to an arm’s-

length transaction between the

employer and the employee

is generally upheld. Thus, a

compensation deduction is

much more likely to be found

reasonable when the employee

is not a controlling shareholder

or when the payment bears

no relation to the employee’s

percentage ownership. This

means that the potential for

compensation being deemed

excessive is not as great for

publicly held corporations

(where the salaries of the high-

est executives are set by an

independent board of directors

not under the control of the

employee) as it is for closely

held corporations.

In many cases, however, true

arm’s-length bargaining is not

possible because the corpora-

tion is either closely held or

dominated by the shareholder-

employee. In these situations,

any arrangements entered into

between the employer and the

employee, even when formally

authorized by the board of

directors, is much more closely

scrutinized. If the Internal Reve-

nue Service (IRS) disallows these

deductions, the taxpayer gener-

ally bears the burden of proving

that the compensation it paid is

reasonable. Therefore, corpora-

tions should exercise care in

structuring their compensation

arrangements and maintain

adequate documentation.

The IRS and the courts

have generally taken one of

two approaches in determining