What is Reasonable Compensation?
In the H.W. Johnson, Inc. Tax Court case issued yesterday, the Court found that a bonus arrangement paying out close to 95% of the net income of the company to the two key shareholders was in fact, reasonable compensation. They also found that a $500,000 payment to an affiliated company was allowed even though there was no written contract and the tax return simply recorded it as an administrative expense.
H.W. Johnson, Inc. was in the residential concrete construction business in Arizona. H.W. and Margaret Johnson had formed the company in 1974 and had turned most of the operations over to their two sons Bruce and Donald. Margaret owned 51% of the stock and the two sons owned the remaining shares. The company was profitable, however, during the early 2000s, the company’s net income increased dramatically. Although income was up, it was difficult to find concrete to get all of their jobs done timely. The brothers tried to convince their mother to invest in a concrete production company, but she resisted. Therefore, they formed their owned with other investors.
Revenues for 2003 were about $24 million and they jumped to $38 million in 2004 (the years under audit). Net income before taxes was $387,706 and $348,579 for these two years, respectively. They also had a history of paying out dividends. The key issue was the amount of compensation to Bruce and Donald. During 2003, they earned a total of $4,025,039 and it jumped to $7,300,916 in 2004. This compensation was based on salary plus bonus based upon a percentage of sales.
The IRS argued that these payments were excessive. The Tax Court disagreed and outline the five factors used in determining reasonable compensation:
- The employee’s role in the company. Bruce and Donald worked over 60 hours a week and were in charge of the two divisions (East and West). This was in their favor.
- A comparison of compensation paid by similar companies. The IRS conceded it was difficult to find other similar companies making these profits. Also, compensation had been paid consistent with the bonus plan.
- The character and condition of the company. In favor of the company.
- Potential conflicts of interest. The main argument by the IRS.
- Internal consistency of compensation arrangement. Very consistent. In favor of the company.
The IRS tried to asset that an independent investor would require an adequate return on equity greater than earned the company. The court did not agree.
The $500,000 payment to their controlled entity was allowed due to various factors. It is likely that it would not have been an issue if they had labeled it differently on the tax return.
The bottom line is it is important to be consistent and document your compensation arrangements as this court shows.
Paul Neiffer, CPA