Executive Compensation-Tax Court Determines That Compensation Paid Was Reasonable And Deductible

In K & K Veterinary Supply, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2013-84, the Tax Court faced the question, among others, of whether amounts paid as compensation to officers and certain employees were reasonable, within the meaning of IRC section 162(a)(1), and therefore tax deductible.

In this case, the corporation in question, K & K Veterinary Supply, Inc. (the “Company”), claimed the following tax deductions for salary, which the Commissioner challenged:

2006 2007

J. Lipsmeyer $732,300 $559,100 M. Lipsmeyer 134,400 133,500 ________ ________ Total 866,700 692,600

D. Lipsmeyer 590,500 470,000 Stewart 183,000 192,700 _______ _______ Total 773,500 662,700

In reviewing this case, the Tax Court noted that IRC section 162(a)(1) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. A taxpayer is entitled to a deduction for salaries or other compensation if the payments were reasonable in amount and are in fact payments purely for services. Sec. 1.162-7(a), Income Tax Regs. Whether the compensation paid by a corporate taxpayer to an officer or employee was reasonable is a question of fact. The following 10 factors may be taken into account:

1. Employee qualifications. An employee’s superior qualifications for his or her position with the business may justify high compensation.

2. Nature, extent and scope of employee’s work. An employee’s position, duties performed, hours worked, and general importance to the corporation’s success may justify high compensation.
3. Size and complexity of the business. Courts consider the size and complexity of a taxpayer’s business when deciding the reasonableness of compensation paid to its shareholder-employees. The Tax Court has considered a company’s sales, net income, gross receipts, or capital value in determining a company’s size, as well as the number of clients, the number of employees, growth in these areas and compliance with government regulations.

4. General economic conditions. General economic conditions may affect a company’s performance and thus show the extent of the employee’s effect on the company. Adverse economic conditions, for example, tend to show that an employee’s skill was important to a company that grew during the bad years.

5. Comparison of salaries paid with gross and net income. Compensation as a percentage of a taxpayer’s gross and net income has been considered in deciding whether compensation is reasonable. In most cases the comparison of salaries to net income is more probative.

6. Prevailing rates of compensation. A comparison of the compensation under consideration and the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry is a very significant factor.

7. Salary policy of the employer as to all employees. Courts have considered the taxpayer’s compensation policy for its other employees in deciding whether compensation is reasonable. This factor focuses on whether the entity pays top dollar to all of its employees, including both shareholders and nonshareholders.

8. Compensation paid in previous years. This factor applies when a corporation is deducting compensation in one year for services rendered in prior years.

9. Comparison of salaries with distributions and retained earnings. The absence of dividend payments by a profitable corporation is a factor that may be considered in addressing the reasonableness of compensation.

10. Whether the employee guaranteed the employer’s debt. Courts have also considered whether an employee personally guaranteed the employer’s debt.

Applying the foregoing factors, the Tax Court concluded that the officer’s and employee’s salaries was reasonable, and therefore upheld the claimed deductions,