For years you treated the company like a part of the family. When business was slow and the cash register was bare, you reached into your wallet with no hesitation. You cheerfully paid for supplies with your credit card and guaranteed capital expenditures with a second mortgage on your house. So now that the company is doing well, itÕs payoff timeÑyou and your family can pay yourselves whatever you need to live well, right?
Wrong, of course. Under Internal Revenue Service excess-compensation rules, a companyÕs tax returns may be challenged if it claims deductions for compensation which the IRS regards as inappropriate. If those deductions are disallowed, the money cannot be deducted as a business expense; instead, the payments are considered dividends, which are subject to taxes as corporate income. The courts can also impose penalties, usually in the form of interest on the excess amount that was improperly deducted for the period since it was claimed.
Many family business executives are surprised to encounter excess-compensation rules. After all, thereÕs no limit on what you can put into a company, so why should there be restrictions on what you can take out as long as you declare it as income and pay taxes on it? But the IRS regularly challenges companies it thinks are deducting too much, not only in salaries but also in bonuses and other forms of compensation, as well as in travel and entertainment expenses
What many business owners may not realize is that what is considered excessive is often a matter of interpretation, which, like many tax issues, can ultimately be resolved only by negotiation. The case of Burton Enterprises, a family business in the state of Washington, illustrates how the process works. It also suggests that the taxpayer doesnÕt always end up on the short end of the IRS stick.
Burton Enterprises made kitchen accessories and had total sales of $4.6 million in 1990. At that time, it paid the founderÕs daughter a salary of $51,750 as president, the founderÕs son $10,750 as secretary/treasurer, and the daughterÕs husband $17,750 as vice president for sales and marketing. Decidedly modest wages, to be sure, but the company also paid a bonus of $700,000 to the daughter, $100,000 to the son, and $200,000 to the daughterÕs husband.
The IRS challenged the bonuses as unreasonable, and when no compromise could be negotiated, the issue ended up in tax court, which ruled on the case in 1997. Although the IRS wanted the daughterÕs bonus cut to $258,880, the court approved $474,000; her husband got $54,000 more than the $88,890 the IRS had approved, and the son got the full $100,000 instead of the $56,630 the IRS was willing to allow him.
The court appeared to approve larger bonuses on the basis of testimony from expert witnesses who offered comparative data on bonuses paid by similar companies. Larger bonuses were also justified because of the scope of the family membersÕ responsibilities. Burton Enterprises was a lean company, and senior executives performed a variety of functions, from designing products to making sales calls to writing brochures.
The decision noted a lengthy list of factors that are relevant in determining reasonableness, including: the employeeÕs qualifications; the nature, extent, and scope of the employeeÕs work; previous compensation paid to the employee; the size and complexity of the business; prevailing economic conditions; comparisons of salaries with distributions to stockholders; rates of compensation for comparable positions in comparable firms; salaries paid to all company employees.
First line of defense
For family business executives who want nice paydays and also want to avoid excess-compensation problems, there are several steps to take to ensure that payments pass muster with the IRS. The first line of defense is comparables. Timothy OÕRourke of Matthews, Young Management Consulting in Hillsborough, North Carolina, notes that youÕre at risk of violating excess-compensation rules if you pay people Òabove the average for similar companies.Ó So the answer, he says, is to make sure you pay family members about what they would make at comparable companies.
But how do you define and locate comparables? If you run six supermarkets, you canÕt compare your salary to the head of Safeway or Kroger. Rather, you need to compare your company with companies in similar industries with a similar scale of operations and roughly similar revenues.
Once youÕve identified those companies, Òyou always start by looking at public companies, because that information is available,Ó says Arthur D. Levy, a partner at J.H. Cohn LLP and chairman of the board of the Family Business Council of Greater New York. Levy adds that the goal is to be able to tell the IRS, ÒWeÕre comparable to that company doing $100 million a year, and the chairman there is getting $3 million a year, and therefore I can get this compensation.Ó
While publicly held companies list compensation for their most senior executives in their annual reports, 10-Ks, and proxy statements, many family owned companies find that the companies that most resemble theirs are privately held. Jim McMahon, a managing director at Analytical Compensation Services in Phoenix, points out there is a substantial amount of survey data on compensation in privately held companies. For example, Panel PublishersÕ annual ÒOfficer Compensation ReportÓ provides data on companies with sales under $100 million. McMahon also recommends data from the Economic Research Institute in Redmond, Washington. Watson Wyatt, a major consulting firm with a data services division in Rochelle Park, New Jersey, also publishes compensation data.
In short, a lack of information Òusually isnÕt a problem,Ó according to McMahon. Other experts disagree, but for those industries in which information is scarce, McMahon notes, a company can gather comparability data from a sampling of other companies on its own. Some companies still do such surveys themselves, he says. But because many today are concerned about exchanging data with potential competitors, or worry the Government may view such an exchange as collusion, most companies rely on a third partyÑa compensation data services firmÑto do the survey for them.
Besides data from comparable companies, the other key tool is job descriptions. If your son the CFO makes more than the CFO at similar companies, maybe heÕs also doing a different job with more responsibilities, or even performing more than one job. OÕRourke notes that, Òa number of cases have been won by the owner of a business who was clearly paying himself more than the typical president of a company that size because he was able to show he was performing the duties of a number of different positions that in a typical company might have several people performing them.Ó Thus, if your daughter is not only sales manager but also head of advertising and public relations, she can be paid more than the garden variety sales manager.
While a written job description can be crucial, it can also be a two-edged sword. ÒA lot of people donÕt want to write down what they are responsible for because it may not look like much,Ó notes Gerald Le Van, managing director of the Le Van Companies in Charlotte, North Carolina, and author of The Survival Guide for Business Families (Routledge, New York, 1998).
In addition to job description, superior qualifications can also help justify high pay. If your brotherÕs got a Ph.D. in English literature, that doesnÕt warrant paying him lavishly as a factory manager. But if he earned an advanced degree in Asian studies, speaks fluent Mandarin, and now heads Asian sales, that may justify a paycheck substantially larger than the going rate for someone less qualified who heads Asian sales at other companies of similar size.
Generally, if you do your homework in seeking comparables, Levy says, excess-compensation cases Òare a very hard fight for the IRS to make. As long as you have some basis, you can hang your hat on almost anything.Ó
Even if you have nothing to hang your hat on, there are still a couple of other defenses, according to Eugene L. Vogel, a tax partner at Rosenman and Colin in New York City. One is a record of success. Vogel recalls a case involving a family advertising agency in which the payments to the founder were challenged: ÒWe showed that he was a very hard worker and over the last several years he had tripled the companyÕs profits. If he were a stranger [another employee], he would have gotten a lot of money for that.Ó
ThereÕs another argument the IRS doesnÕt like, but the business owner can find useful, according to Vogel. This is that someoneÕs pay Òmay be a little high now, but his pay was low when he started, and itÕs only fair to make it up.Ó Vogel says this pattern is common Òin any startup business, where you and your spouse worked for very little, whereas in an arms-length situation you would have had more salary. You took almost nothing at first and now itÕs a big success, and youÕre paying yourself a bonus. You justify it by saying itÕs a return for how little you earned before. This finds a sympathetic hearing in court.Ó
That doesnÕt mean you have to go to court. Excess-compensation problems usually arise when an IRS field agent examines a tax return and challenges a deduction. If the company disagrees, Vogel explains, Òthe next stage is an appeals office of the IRS, and the people there are supposed to deal with litigation hazards. If youÕve got a reasonable, intelligent IRS appeals officer, his job is to settle cases, so he may not like it [the making up for lost time argument], but he knows if you go to court you have a good chance of winning.Ó
The S corp solution
Rather than run the risk of an IRS challenge, business owners can circumvent the whole excess-compensation issue by structuring their company differently, according to Clifford Starkins, a principal at Adams & Becker, an accounting firm in Huntington, New York. ÒAs soon as you start to have a company that is realizing a lot of income and you want to take it out,Ó he says, Òyou should start thinking about going to an S corporation type of arrangement.Ó
Arthur Levy agrees: ÒThe easiest way to avoid the whole issue is to become a Subchapter S corporation; the income of the company is included on individual shareholdersÕ tax returns.Ó Subchapter S corporations have their own problems, of course, including the limit of 75 shareholders, none of whom can be non-resident aliens, or entities such as partnerships or corporations. If your company is growing and you feel constrained by these limits, a limited liability corporation (LLC) can give you the same protection. ÒThose can be a lot bigger than what you would understand to be the traditional Sub-S,Ó Levy observes.
Some companies opt for traditional corporate structures, for a variety of reasons having little to do with tax issuesÑfor instance, if they seek liability protection or want to raise capital in the public markets. The way owners of corporations increase their income, Levy says, is to Òpay dividends like the big boys.Ó Of course, the profits of public companies are taxed twice, once at the corporate level and again when money is paid out in dividends. But large sums paid out as dividends instead of salary or bonuses have the same tax consequences for the recipients, without raising excess-compensation issues. ÒThatÕs the ultimate solution,Ó Levy says.
Harvey D. Shapiro is a writer and consultant in New York City specializing in business and finance.
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In the 1998 case of a company called Labelgraphics, a tax court reversed an IRS ruling that the presidentÕs salary was excessive, but denied a writeoff for a portion of the superbonus paid to the same executive. According to the ÒChief ExecutiveÕs NewsletterÓ (February 1999), the amount of the bonus at issue was three times as high as the companyÕs next-largest bonus. In addition, it had created a negative return on equity that year. The court rejected the often-used argument that the superbonus was justified because it made up for earlier years when the president was underpaid.
As a result, the newsletter, a publication of the CEO Club in New York City, advises: ÒKeep bonuses in perspective. As you approach the end of the year, donÕt pay bonuses that are out of proportion to sales and previous payments. A bonus paid in late December can look like a dividend paid just to keep profits down.Ó
The CEO of a growing company, Dexsil Corp., eventually prevailed against the IRS in another case. The CEOÕs salary and bonus were based on a percentage of sales. From 1983 to 1990, the company had grown from 3 to 30 employees and from $113,000 to $4.9 million in sales. His compensation grew from $12,000 to $488,000 during those seven years, but it was based on the same percentage of salesÑ11 percent.
The IRS ruled that the CEOÕs salary in the last year was unreasonable, and rejected $168,000 of the amount the company had tried to deduct. A tax court upheld the ruling, but an appeals court later reversed it. The hefty payments were legitimate because of the companyÕs performance in these years. The executive newsletter noted: ÒAn ongoing system of compensation based on sales doesnÕt become excessive just because the company starts doing well in later years. The 11 percent formula was set up in good faith, the court said, and should be followed.Ó ÑHoward Muson