Be reasonable! The Internal Revenue Code allows a business to deduct a “reasonable allowance for salaries or other compensation” it pays to executives and other employees. When an executive is also a shareholder of a C corporation, the IRS may challenge compensation it believes is unreasonably high, arguing that the excess is really a disguised dividend. Dividends aren’t deductible, so by characterizing payments as deductible compensation, the company reduces its tax bill. Compensation vs. dividends This incentive to pay high salaries isn’t as powerful as it once was. Qualified dividends are now taxed at only 15% — compared to ordinary tax rates on compensation, which can be as high as 35%. So a company that treats payments as compensation rather than dividends to save corporate taxes may significantly increase the recipient’s tax liability. Still, depending on their respective tax brackets and other factors, a company and its owners may enjoy an overall tax savings by characterizing payments as compensation. Under those circumstances, however, the IRS may attempt to reclassify a portion of compensation as dividends. Guidance from the Seventh Circuit In Menard, Inc. v. Commissioner of Internal Revenue, the Seventh U.S. Circuit Court of Appeals provided valuable insight into the meaning of reasonable compensation. John Menard, CEO of the retail home improvement chain that bears his name, was paid approximately $20 million in 1998. The Tax Court had ruled that $7 million was reasonable compensation and that the remaining $13 million was a nondeductible dividend. In reaching this conclusion, the Tax Court applied the Seventh Circuit’s “independent investor test,” which presumes that compensation is reasonable if the company’s investors “are obtaining a far higher return than they had any reason to expect.” The Tax Court found that this presumption had been rebutted by evidence that other home improvement chains paid their CEOs substantially less. It adjusted Menard’s deductible compensation using a formula based on the compensation competitors paid their CEOs and returns on investment their investors received. The Seventh Circuit rejected this decision. It found that the Tax Court’s formula failed to consider all of the CEOs’ full compensation packages, including severance packages, retirement plans and perks. It also ignored differences in their responsibilities and performance. The evidence showed, for example, that Menard worked long hours and was involved in every detail of the company’s operations; similar information about his competitors wasn’t included. The Seventh Circuit also noted that the Tax Court had disregarded the level of risk associated with Menard’s compensation. The company had a good year in 1998, the Seventh Circuit observed, but if it had lost money, Menard’s total compensation — which was primarily performance-based — would have been only $157,500, regardless of whether Menard was at fault. Yet the Tax Court focused on Menard’s 1998 pay without regard to the fact that his compensation was likely to vary substantially from year to year. A custom approach The Menard case illustrates how important it is to determine the reasonableness of compensation on a case-by-case basis, weighing executives’ actual responsibilities and performance, the level of risk involved, and other factors unique to their situations. • |