Tax Court Applies Independent Investor Test to Compensation

Published date01 May 2017
Date01 May 2017
© 2017 Wiley Periodicals, Inc.
Published online in Wiley Online Library (
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.
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

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