Unreasonable compensation in PSCs.

• Author: McKinney, Hal, Jr.
• Position: Personal service corporations

Many practitioners routinely advise clients that a personal service corporation (PSC) may pay very high salaries to the key shareholder-employees who provide the corporation's services without worrying about having them reclassified as dividends--still taxable to the employee, but not deductible by the corporation. Generally, excessive compensation issues arise in "product," as opposed to "service," enterprises, in which something--usually some form of capital--other than the individuals' efforts is responsible for generating the corporation's net income.

Some recent cases indicate that this advice may need to be reconsidered. Sec. 162(a)(1) permits deduction of a reasonable compensation for services actually rendered. Regs. Secs. 1.162-7 and 1. 162-9 echo these words and add three concepts: (1) the payments must be purely for services; (2) both cash and in-kind payments count; and (3) donations cannot be deducted.

The often-cited Elliotts case, 716 F2d 1241 (9th Cir. 1983), concerned a farm equipment dealer (definitely not a classic personal service business). The court stressed five factors in its decision: (1) the shareholder-employee's role in the company; (2) what similar companies paid similar employees; (3) the size and complexity of the company's business and its economic climate; (4) the shareholder-key employee conflict of interest and the need for fairness to the shareholder; and (5) the internal consistency of the key employee's compensation--consistent not only with the compensation of other employees, but also with the employer's compensation formulas, operative incentive system, employment contracts and, presumably, corporate minutes. Subsequent cases seem to use combinations of these factors--variously weighted for various facts and circumstances--to reach their decisions.

The most important thing to remember in examining recent service corporation cases is that the results are very dependent on the facts and circumstances of each case. The next most important factor is that the first court that considers the facts and circumstances of a case is the one that has prime jurisdiction. Later appeals must show clear error on the original court's part to have its decision changed. of late, the Tax Court seems to be the jurisdiction in which the IRS is having the most success. All of these factors may make early construction of the taxpayer's factual case and successful satisfaction of the IRS's concerns the most crucial elements of success.

Four...