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Tax Court Determines That Officer-Shareholder Compensation is Not Reasonable

By Joel N. Crouch on March 16, 2022
In a recent memorandum decision, Clary Hood Inc. v. Commissioner, T.C. Memo. 2022-15, the Tax Court considered the issue of reasonable compensation to an owner/executive of a construction company. Unfortunately, the Tax Court held that the company failed to establish how the amount it deducted as compensation for its CEO and shareholder was both reasonable and paid solely as compensation for his services. To add insult to injury, the Tax Court held the company liable for an accuracy-related penalty for one of the years under consideration.

Most readers of this blog know that, pursuant to IRC Section 162(a)(a), a corporation may deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. This includes reasonable allowance for salaries or other compensation, such as bonuses, for personal services actually performed. Whether payments are reasonable and for services are questions of fact to be determined from all the facts and circumstances of a particular case. Because the corporation can deduct payments made to an employee as compensation, where an employee is also a shareholder, the IRS is on the lookout for compensation that appears to be excessive and a disguised nondeductible distribution. As the Tax Court in Clary Hood says, “[a]n ‘ostensible salary’ paid by a closely held corporation to one of its shareholders is likely to constitute a disguised dividend where the amount is ‘in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees’”.

The Tax Court described Clary Hood Inc. and its founder, Clary Hood, as the “epitome of the American success story”. The company was founded by Mr. Hood and his wife in 1980 and they were the sole shareholders and members of the board. The couple grew the company from nothing to a very successful construction company, along the way sacrificing Mr. Hood’s salary in order to make payroll during lean times. Despite numerous challenges, Clary Hood Inc. thrived and in 2014, Mr. Hood and his advisors concluded that he had been uncompensated in prior years. In 2015, the board, i.e., Mr. Hood and his wife, set Mr. Hood’s salary at $168,559 and his bonus at $5 million, with similar compensation in 2016. The IRS examined Clary Hood’s 2015 and 2016 Forms 1120 and determined that that Mr. Hood’s compensation for the years 2015 and 2016 was not reasonable. The IRS issued a notice of deficiency claiming that Clary Hood owed additional tax of $1,581,202 and $1,613,308 for 2015 and 2016, respectively and accuracy related penalties of over $300,000 for both years.

In its decision, the Tax Court noted that the parties agreed that “Mr. Hood was entitled, to some degree, to additional compensation for the prior services he rendered as an employee of [Clary Hood, Inc.] during portions of the review period”. However, in holding that Clary Hood was not entitled to deduct the full amount of “compensation” paid to Mr. Hood, the Tax Court said that Clary Hood failed to adequately establish how the entire amount was both reasonable and paid solely as compensation for his services to Clary Hood during 2015 and 2016.

The Tax Court considered the following factors when determining reasonable compensation:

• The employee’s qualifications;
• The nature, extent, and scope of the employee’s work;
• The size and complexities of the business;
• A comparison of salaries paid with gross income and net income;
• The prevailing general economic conditions;
• A comparison of salaries with distributions to stockholders;
• The prevailing rates of compensation for comparable positions in comparable concerns; and
• The salary policy of the corporation as to all employees.
In addition, because Clary Hood was a small corporation with a limited number of officers, the Tax Court also considered compensation paid in prior years and Mr. Hood’s personal guaranties of Clary Hood’s debts and other obligations.

Although some of the factors favored Clary Hood, the Tax Court held that a substantial portion of the compensation paid to Mr. Hood was not reasonable, because (1) Clary Hood had never made any shareholder distributions, (2) there was no written agreement regarding Mr. Hood’s compensation, and (3) Mr. Hood had a habit of making decisions, including his salary and bonus, without consulting the other officers. In addition, the Tax Court noted that Mr. Hood’s salary and bonus far exceeded the salary of similarly situated individuals in the same industry.

With respect to the accuracy-related penalties, the Tax Court held that Clary Hood reasonably relied on its tax advisors for the 2015 tax year, but not for the 2016 tax year.

For questions regarding this blog post or any other civil or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.