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'unreasonable Compensation'
 

Unreasonable compensation is the IRS's way of telling you that you are paying yourself too much salary. Although the absence of concrete rules makes it difficult for the IRS to prove its point in court, it hasn't stopped the agency from trying.
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Some years ago, the Internal Revenue Service dispatched an agent to comb George Howell's personal tax returns and those filed by the two companies Howell owns and heads -- Lakeside Supply Inc. and Water Products Inc. What the agent found is that Howell, the inventor of a well-known aquarium filter, had deducted business expenses he couldn't properly substantiate. There were repairs that totaled $2,921, insurance premiums that added up to $2,441, and payroll taxes that came to $1,526, just to name a few.

But that wasn't the worst of it. Howell, the agent discovered, had paid himself a generous salary compared to what other small businesspeople earn. It was so generous that the agent concluded it was "unreasonable," and said so in three Notices of Deficiency that were mailed in the summer of 1979. One went to Howell, another to Lakeside Supply, and still another to Water Products.

The notices demanded the payment of several hundred thousand dollars in taxes, but Howell, a lanky, one-time auto worker, balked. He hired an attorney and decided to contest the unreasonable-compensation charge.

Unreasonable compensation is what the IRS considers to be excessive, e.g., paying yourself more than your peers earn. The reason that it is illegal is that it deprives the IRS of tax dollars. Simply stated, the government gets more money when a company's profits are paid as dividends than it does when they are distributed as wages. This is because wages are taxed once, while dividends are taxed twice -- at the corporate level and again when they are received by the shareholder.

Just how many unreasonable-compensation suits are brought each year isn't clear. The IRS doesn't keep such statistics, and the most recent figures available from Commerce Clearing House Inc. date from 1969 to 1979. During those 10 years, 424 unreasonable-compensation cases made it to trial, but that, tax attorneys and accountants insist, is only the tip of the iceberg. "We in the Atlanta office have had several excessive compensation cases," notes Douglas J. Lundell, a partner in the accounting firm of Main Hurdman, "but none has gone to court."

That is not atypical. More than 90% of all unreasonable-compensation cases never make it to trial, meaning that for every chief executive officer who takes his case to court, at least another nine simply agree to pay up when challenged by the IRS.

As a rule, these challenges are levied as part of routine audits. "There is no specific trigger," says Gordon D. Henderson, a New York attorney, "The IRS picks up a business return for audit, they look at the salaries paid to the top people, and ask themselves if the amount paid is reasonable."

Perhaps the best way to avoid problems with the government's unreasonable-compensation rules is for CEOs to set their salaries and bonus formulas before their companies become big money makers. "In the regulations on compensation," Lundell says, "there is a provision that says a compensation package that is reasonable when it is structured will usually remain reasonable. So, generally, if a profit-sharing bonus is built into the company when it is started, it should still be considered reasonable later on when the company becomes profitable."

Another way to avoid problems is to pay salaries along with dividends. But Howell's Water Products didn't. It paid him only a salary (see box, page 118) -- a generous salary -- and that is what got him and his company into trouble, says F. Michael Kovach Jr., the trial attorney assigned by the IRS to handle the case.

According to Kovach, the IRS agent who audited Howell looked to see if Water Products had paid dividends. It hadn't, so the auditor immediately looked around for evidence of unreasonable compensation. He found that for the tax years 1974 through 1976, Howell had been paid a sizable salary by Water Products -- $150, 112, $174,168, and $217,780, respectively. Those figures amounted to about 15% of the company's gross sales ($1.10 million in 1974, $1.18 million in 1975, and $1.31 million in 1976).

Based on those revenue levels, the IRS concluded that here was a case of unreasonable compensation, and it sent out its Notices of Deficiency. But Howell had his own axe to grind. He told his attorney, David Laro, that the IRS agent had not completed the audit by the time the statute of limitations was set to expire. Howell went on to say that when the agent found he was in a bind, he phoned and asked Howell to voluntarily extend the statute. As Laro remembers it, the agent told Howell that his job was on the line, and Howell, feeling sorry for him, agreed to help out.

Kovach, questioned later about this, concedes that there were problems with the agent who performed the audit, but he says the man was in no danger of losing his job. If Howell had refused to sign the extension, Kovach explains, the IRS simply would have mailed Howell a letter on the date of expiration, demanding the payment of whatever taxes it believed were due. By signing the extension, Kovach says, Howell bought himself some time.

But Howell doesn't see it that way. According to Laro, Howell thought he was doing the IRS agent a favor -- one that was not repaid. "When [Howell] saw the ultimate assessment, he had little choice bat to appeal," Laro says. "We felt the assessment was unreasonable." In late 1979, Laro went to the appellate division of the IRS and, on Howell's behalf, asked that another audit be performed. The appellate division issued an order to that effect, but there was trouble here, too. "The problem," Laro explains, "was that the person they sent to do the new audit was the same person they sent out to begin with."

Howell and Laro were no happier with this second review than they were with the first audit, so Laro took the case a step further, to the U.S. Tax Court in Detroit.

"We again said to the government that the case had never been properly audited, and the government again sent out a new auditor," says Laro. "This time, it was an agent who knew what he was doing."

As a result of that third review, certain noncompensation issues included in the case (the unsubstantiated deductions) were resolved for an undisclosed amount. The IRS, however, continued to question the amount of money Howell had paid himself -- despite the fact that unreasonable-compensation cases are usually very difficult to prove, because of the lack of concrete rules. The tax code doesn't specify what a particular job in a particular industry should pay. On the contrary, it leaves the courts free to decide each case within a certain framework.

That framework was established in the landmark Mayson Manufacturing Co. case, handed down in 1949. Under it, the courts, in deciding unreasonable-compensation cases, are required to consider the nature and size of the business involved: the qualifications of the employee; the scope of the employee's work; and the ratio of salaries to the gross and net income from the business.

The courts also must consider compensation paid in past years; whether dividends were paid; the relationship between the employee and the corporation; and what comparable businesses are paying employees performing the same services.

With George Howell, those were tough issues. Howell is a self-educated entrepreneur who runs his business the way he runs his life -- independently. He wasn't eager to talk about himself or his finances, especially to the IRS. "I got the impression," Kovach recalls, "that [Howell] didn't want anyone to know exactly how much money he was making or what he was doing. He was uncomfortable every time we talked about his business."

On February 25, 1982, Howell's case went to trial. Laro's strategy was to show that Howell was worth more than most CEOs because his contributions to his companies were unusually diverse. Laro intended to point out, for example, that Howell invented the primary product he sold, an aquarium filter. A similar tack had already proved successful in an earlier case involving Appleton Electric Co., in which the court ruled that more than $250,000 a year was fair compensation for a CEO who was also an inventor. The court declared that a salary of $100,000 per year would be adequate if the executive rendered only executive services. It also noted, however, that the executive's greatest service to the company was as an inventor.

Howell, then, had to show that he, too, was an inventor. During the trial, he offered the court a brief synopsis of his background. He had graduated from high school at 17, then had gone to work at the local Chevrolet plant. When it became obvious that he couldn't afford to go to college, he enlisted in the Navy. At the end of his tour of duty, he returned to Michigan and to Chevrolet. To supplement his education, he took several classes at General Motors Institute. To supplement his income, he accepted freelance diving jobs on the side.

That experience ultimately led to the opening of Lakeside Supply, a company that specializes in retail and wholesale diving equipment. It was incorporated in 1959, with Howell as its sole shareholder.

At about that time, Howell began to develop his talents as an inventor. In 1962, he got the idea for the aquarium filter that ultimately led to the creation of Water Products Inc.

It was Christmas, and Howell had purchased an aquarium for his wife. "She was less than thrilled," he told the court, "but we set it up, put some fish in it, and promptly had problems. . . The water got cloudy and milky and [the fish] all died."

Howell went back to the store where he bought the aquarium and complained. "[I] was told that I hadn't set it up right; I hadn't sterilized the gravel, and I hadn't sterilized the tank. . ." He went home and tried again. Once again, the fish died.

But this time he didn't go back to the store. He relied on his own inventiveness. "At the same time that I was running the dive shop, I ran explosive classes," he testified. "One of the basic ingredients in dynamite is [kieselguhr], which is the German word for diatomaceous earth. . . I simply had my wife make a bag. We connected it onto a pump, put diatomaceous earth on the inside, and filtered the aquarium. The fish stopped dying, the water got very clear, and I had no more problems."

Howell was delighted with the success of his homemade filter. He started producing filters in his living room. "If we built 144 units over the weekend," he recalled, "I would go out and sell 144 units."

To finance his venture, he borrowed money on his car, his insurance, and his house. He went on the road to sell his product.

At this point, Laro prodded his client. He wanted to show Judge Meade Whitaker that Howell was an inventor and a salesman and a marketing expert. He figured the more hats Howell wore, the more Howell would be worth.

"My prime job in marketing that filter was to educate people on how it operates, what it did," Howell explained. He told the court about visiting pet-products stores and getting the cold shoulder from distributors who felt that the last thing they needed was another filter. So, Howell said, he bought a binocular microscope, went into the dealer's store, selected a tank with a problem such as hazy water, and then asked the dealer if he would allow him to show what his filter could do.

"[The dealer] will usually put up a little resistance, like, 'Oh, we're not having any trouble with it.' . . . And I will say, 'Now, let me show you something,' and I'll take the water from the aquarium, culture it under a microscope, and show him what's in his water . . . It's very simple and it's very dramatic. Now, that dealer knows the filter works, and he knows he's got to have it in his store."

Laro concluded this line of questioning by hammering home his point.

"Who designed the manufacturing process of Water Products?" he asked.

"The tools? I do," Howell replied.

"Who designed the system of assembling the product?"

"I do," Howell said.

"Who is responsible for the purchasing of the materials that went into the product for Water Products?"

"I am," Howell answered.

The questions kept coming.

Who is in charge of research and development for Water Products? Who is in charge of any new product development? Of the financial affairs of Water Products? For Water Products's credit arrangements? For overseeing national sales and marketing? Each time, the answer was Howell himself. By the end of the questioning, Laro had made his point.

"Here was a man," Laro insists, "who invented a product, who took it to market and established a national and international chain of distribution for the sale of that product all by himself."

Normally, that would be an excellent defense. Unfortunately, the judge decided the case on a couple of other issues -- the commission Howell received on the sale of each aquarium filter, and the amount CEOs of similar-size businesses in Michigan were being paid.

According to the judge, Lakeside Supply had paid Howell a commission of $1 each time a filter was sold. When the filter business was transferred to Water Products, the practice continued. But this time, Water Products paid the commission to Lakeside, and it, in turn, passed the money along to Howell. The judge decided that this was not a true commission, but a royalty, and, as such, meant that Howell was being compensated as inventor.

The judge also concluded that Howell had paid himself too much money compared to what others in the area were earning. An annual survey, conducted by the Employers Association of Detroit, showed that the CEOs of like-size companies in the Detroit area earned $75,000 to $80,000, less than half of Howell's salary.

The IRS's Kovach had introduced the study into evidence during the trial and called as a witness Brian W. Gill, a vice-president at the Employers Association of Detroit. Laro had challenged the study, arguing that it wasn't applicable.

"Of the companies you surveyed, how many of them manufactured aquarium filters?" Laro asked Gill.

"To my knowledge, none." Gill said.

"How many of the companies surveyed were in the Flint, Michigan, area?"

"None," Gill said.

"How many of the chief executive officers surveyed were also inventors?"

"I have no way of knowing that," Gill replied.

"How many of the chief executive officers lent money to the company?"

Gill did not respond.

But the point was lost on the judge. While he reduced the tax deficiencies determined by the IRS, he still ruled in Uncle Sam's favor. On February 9, 1983, he issued his final decision. Howell was told he owed the IRS $56,087 -- $110 for the 1973 tax year; $10,522 for 1974; $27,423 for 1975; and $18,032 for 1976. His company, Water Products, was to remit $132,288 -- $2,070 for 1973; $40,154 for 1974; $42,202 for 1975; and $47,862 for 1976. Not included was $10,506 owed by Lakeside Supply, interest (which was added later by the IRS), and his attorney's fees (more than $20,000), which brought the total bill to more than $225,000.

For Howell, that was the end of the fight. An appeal was out -- he had no legal grounds for such an action -- so he wrote a check to the IRS for the amount the judge specified. Needless to say, Howell remains bitter about the whole incident and is considering moving his business, which is now based in Florida, outside the country. Someplace in the Caribbean, he says, where the IRS is less likely to get at him. As Laro says, "Anybody who is a businessman, who pays himself what he thinks is reasonable, and then later is told by some outside source, such as the government, that it was unreasonable compensation, is never going to be satisfied with a [judgment like this]."

Editor's note: George Howell, not unlike many entrepreneurs, is not fond of the Internal Revenue Service, and he says he would just as soon forget his past problems with the agency. In deference to Mr. Howell's wishes for privacy in this regard, we have changed his name and those of his two companies. All other details in the story remained unchanged.

UNCLE SAM'S CLAIM VS. SALES AND SALARY

1974 1975 1976

Water Products's $1.10 mil $1.18 mil. $1.31 mil.

gross sales

Water Products's 38,814 56,660 8,940

net income

George Howell's 150,112% 174,168 217,780

salary

Amount the IRS 61,452%H75,7

56%H110,511%

L%?claimed

was

unreasonable

Last updated: Sep 1, 1983




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