'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.

Tweet

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."

 1 | 2 | 3  NEXT