Posted on Aug 5, 2016

Are you drawing too much salary from your construction company — or perhaps not enough? Be careful: The IRS may challenge deductions for wages it thinks are unreasonable.

In a recent case, the co-owners of a cement contracting business chose to pay themselves a certain amount of compensation, contested the IRS’s refusal to allow part of the compensation as deductible and eventually won the case (H. W. Johnson, Inc., TC Memo 2016-95). The U.S. Tax Court’s decision revolved around the “independent investor” test.

Separate Divisions

The company was owned by the retired founder’s wife (51% interest) and his two sons (24.5% each). It grew to become one of the largest concrete contractors in Arizona, with more than 200 employees. Annual revenue rose rapidly after the sons assumed control of daily operations. When they took over in 1993, the company showed revenue of $4 million. That mushroomed to $23.87 million in 2003 and $38 million in 2004, the two tax years questioned by the IRS.

Each brother supervised a division of the company, overseeing all operations including:

  • Contract bidding and negotiation,
  • Project scheduling and management,
  • Equipment purchase and modification,
  • Personnel management, and
  • Customer relations.

Working 10 to 12 hours a day, five to six days a week, the brothers were at job sites daily and regularly operated equipment. They each were readily available if problems arose and were known locally for their responsive and hands-on management style.

The concrete work that the brothers supervised required considerable technical skill. Over the years, their business built an excellent reputation with developers, inspectors and other contractors for timely, quality performance. As a result, the company routinely won contracts even when it wasn’t the lowest bidder.

During the two years in dispute, the brothers personally guaranteed loans allowing the business to buy materials and supplies. In 2003, faced with the possible disruptions in their concrete supply, the brothers partnered with investors to start a concrete supply business — despite their mother’s objections about the risks. This move allowed the company to prosper when others were suffering.

The board of directors voted to pay the brothers $4,025,039 and $7,300,916 in 2003 and 2004, respectively. But the IRS partially denied the company’s deductions for this compensation, finding that $811,039 for 2003 and $768,916 for 2004 wasn’t reasonable.

Tax Court Outcome

The Tax Court applied the five factor test used by the U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this case would have gone. Based on the appeals court’s landmark ruling in Elliotts v. Commissioner (716 F.2d at 1245-1247), five factors are used to determine reasonable compensation:

  1. The employee’s role in the company,
  2. A comparison with other businesses,
  3. The character and condition of the company,
  4. Potential conflicts of interest, and
  5. Internal consistency in compensation.

According to the court opinion, the IRS argued that the current case hinged on the “fourth Elliotts factor; namely, whether a hypothetical independent investor would receive an adequate return on equity after accounting for [the brothers’] compensation.”

Responding to that argument, the Tax Court said that the annual return after payment of the compensation closely approximated the return generated by comparable companies. Accordingly, it said that an independent investor would have been satisfied with the return.

After examining all the factors, the Tax Court concluded that the compensation paid to the brothers was reasonable under the circumstances and, thus, deductible. Each brother was integral to the success of the business — including performance that resulted in remarkable growth in revenue, assets and gross profit margins during the years at issue.

Takeaway for Contractors

For contractors, the takeaway from this Tax Court ruling is to be sure you’re familiar with the independent investor test and how it applies to IRS challenges of compensation arrangements for shareholder-employees. Although there’s no definitive bright line test on what constitutes “reasonable,” the courts have historically cited several factors that vary by jurisdiction. These include:

  • Amounts similar businesses pay their shareholder-employees,
  • Reasons for paying high compensation (spell them out in your corporate minutes),
  • The nature, extent and scope of the taxpayer’s work,
  • The taxpayer’s qualifications and experience,
  • The size and complexity of the business,
  • General economic conditions,
  • The employer’s financial condition,
  • The employer’s salary policy for all employees,
  • Compensation paid in previous years,
  • Whether the employer and employee are dealing on an arm’s-length basis, and
  • Whether the employee guaranteed the employer’s debts.

No single factor is greater than the other. The decision generally comes down to the number of factors weighing for or against reasonable compensation.

Remember to pay reasonable amounts for services actually rendered. These actions should help protect you if the IRS ever comes calling,

Also, it makes a big tax difference whether amounts paid to owners and other high-income employees are treated as compensation or dividends. Compensation is deductible from the employer’s taxable income; dividends aren’t and effectively represent a second level of taxation on corporate income.

For this reason, some employers choose to maximize the tax benefits by increasing the compensation. However, if a company simply pays its employees whatever it wants, it could find itself in hot water with the IRS. Typically, when the IRS successfully challenges an amount as “unreasonable,” the difference between the payment and a reasonable amount attributable to services provided can’t be deducted.

Best Defense

Of course, reasonable compensation issues don’t always involve excessive amounts. In some cases business owners may arrange for low or even no wage payments to reduce payroll taxes. As a result, the owners must argue with the IRS that they should be paid less, not more. If you find yourself in such a situation, you can bolster your position by spelling out the reasons for a low salary — including plans to use funds for expansion — in your corporate minutes.

The IRS may re-characterize compensation even if the business is running a loss — for an example, see Glass Blocks Unlimited (TC Memo 2013-180, 8/7/13). But, whatever the reason for the agency’s scrutiny, your construction company’s best first response to an IRS compensation challenge is to contact your CPA for professional guidance in building your defense.