Tax Court Outlines When Compensation Packages for Owner-Employees are Reasonable and Therefore Deductible – Los Angeles Income Tax Planning and Income Tax Litigator Attorney Bruce Givner

by Bruce Givner on March 1, 2013

Dr. Fletcher, a certified chiropractor, and Mrs. Fletcher, a registered nurse, bought Thousand Oaks Residential Care I, an assisted living facility, in 1973. In 2002, the Fletchers sold the facility but continued to work there. After the sale, the corporation created a defined benefit plan (pension plan) of which Dr. Fletcher was one of the two participants.

The corporation paid Dr. Fletcher Form W-2 wages of $200,000, $200,000, and $30,000 in 2003, 2004, and 2005, respectively. It also contributed $191,433 and $259,506 to the pension plan for the benefit of Dr. Fletcher in 2003 and 2004, respectively, for a total compensation package of $880,939. The corporation paid Ms. Fletcher Form W-2 wages of $200,000, $200,000, and $30,000 in 2003, 2004, and 2005, respectively. It also contributed $191,433 and $198,915 to the pension plan for the benefit of Ms. Fletcher in 2003 and 2004, respectively for a total compensation package of $820,348.

After an audit, the IRS contended that the compensation packages paid to the Fletchers were not reasonable and disallowed deductions for all of the compensation. Petitioners argued that compensation paid in those years was reasonable and included catchup payments for prior years in which they were undercompensated.

The deductibility of compensation is determined through a two-prong test: the amount of compensation must be reasonable, and the payment must be purely for services rendered. Whether compensation is reasonable is determined by reviewing 1) the employee's role in the company; 2) a comparison of the employee's salary with salaries paid by similar companies for similar services; 3) the character and condition of the company; 4) potential conflicts of interest; and 5) internal consistency. Compensation for prior years' services is deductible in the current year as long as the employee was actually under compensated in prior years and the current payments are intended as compensation for past services. R.J. Nicoll Co. v. Commissioner.

While the Fletchers were an integral part of running the facility, the Tax Court determined that the compensation packages were unreasonable because they did not leave enough of the corporation's assets to be paid back to a hypothetical investor as a return on investment. The Fletchers were overpaid by almost $300 thousand. Thousand Oaks Residential Care Home I, Inc. V. Commissioner Of Internal Revenue.

Givner & Kaye focuses on sophisticated income tax planning and compliance, tax litigation and procedure, estate planning, and asset protection plans for individuals and businesses in Beverly Hills, Calabasas, West Los Angeles, Hollywood, and other areas of Los Angeles, Orange, Ventura, San Bernardino, Riverside and Santa Barbara Counties. Call Los Angeles Estate Planning and Asset Protection Plan Attorneys Givner & Kaye at (310) 207-8008 today.

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