I urge many of you readers, whose first reaction is “this doesn’t apply to me” to: (1) read on and be surprised, and (2) save this article for future use. Like many IRS threats, it could happen to you — and, often, when least expected.

Overview

Many closely held, small and medium-sized business owners are probably not even aware that the IRS can challenge their compensation as being “unreasonable.” (This attack can only be launched against C corporations and not S corporations.) If their challenge is successful, your company will lose the deduction for that compensation, suffer severe financial costs, plus some terrible aggravation — as well as substantial additional accounting and legal fees (win or lose). You are much better off if the IRS is “reasonable,” but part of that depends on your degree of planning, before such an attack. The balance then depends on how you meet and counter such a threat at the time it appears. Here are the ins and outs of being “reasonable.”

Since much of your defense should consist of advance planning, I urge many of you readers, whose first reaction is “this doesn’t apply to me” to: (1) read on and be surprised, and (2) save this article for future use. Like many IRS threats, it could happen to you — and, often, when least expected.

The Vague, Vague Guidelines

The determination of reasonable compensation is highly subjective, because the very guidelines are so generalized and vague. This, in turn, has really left the final determinations up to the courts — and from those court cases, the more definitive rules have slowly developed. Not a good situation, or law.

Section 162(a)(1) of the Internal Revenue Code says that “ordinary and necessary” deductible business expenses include a “reasonable allowance for salaries or other compensation for services actually rendered.” The related IRS Regulation 1.162, is supposed to explain what Section 162 means, but it simply blathers on about “whether the payment is reasonable in relation to services performed” (the so-called “amount” test) and “whether the payments are solely for services rendered” (the so-called “purpose” test).

The same regulation also gives such a vague definition of “reasonable” compensation; that it has resulted in financially supporting many lawyers (and their families) and many accountants (and their families) in many cases, for many years — and for many dollars! The IRS definition:

• “Reasonable compensation is the amount that would be paid for like services under like circumstances (i.e., the amount ordinarily paid for like services by comparable businesses in similar circumstances). The determination of whether an individual’s compensation is reasonable is based on the facts and circumstances surrounding the payments.” How very helpful.

Here are the guidelines derived from that (unhelpful) explanation:

• Your total compensation must be “reasonable.” This includes and aggregates your: salaries, bonuses, commissions, retirement plan contributions, group insurance premiums, all other fringe benefits, etc.
• The services must actually be “rendered.” For example, your children, your spouse or even a dear “friend” must only be paid compensation for genuine services they perform for your company ­­— not just because you are related to them, or you have some other “special relationship” with them.
• “Reasonableness” has been defined (in one of the many, many court cases) as: “Reasonableness is determined by comparing the amount of compensation paid to an individual with the value of services performed. This determination is made on an individual employee basis (most important!) and not in terms of aggregate compensation paid to all employees.”
• In many closely held businesses, the IRS standard is very difficult to apply, since the owners may be the founders and absolute driving force behind the business. Then, when the business becomes much larger and highly profitable — what is reasonable compensation of such individuals?

The Audit Trigger Level

For closely held C corporations only: Based upon nothing but experience, professional feedback, IRS audits, extensive reading and gut-feelings — individual compensation of $400,000 or more is certainly enough for the IRS to consider whether to question the compensation. The higher that amount, the more likely the audit chances. $1 million and up is almost a sure IRS challenge to the individual’s compensation. Unfortunately, I understand that this trigger amount varies widely in different parts of the country. While the $400,000 figure may be realistic for big cities such as Los Angeles, New York or Chicago — in other areas of the country (e.g., Left Armpit, Mississippi), $200,000 of compensation might trigger the same IRS questions.

Keep in mind that “compensation” also includes retirement plan contributions and other fringes. So a $350,000 salary can easily result in over $400,000 of total “compensation.”

The Cost of Any Disallowance

Understand just how serious any disallowance of compensation can be. The deductible salary payments (which are then disallowed), usually become non-deductible “dividends.” Thus, your corporation owes federal (and state) income taxes on the amount disallowed — plus, naturally, interest and (possibly) penalties (not to mention the related accounting and legal fees). Also (conceivably), a portion of your retirement plan contributions, related to that part of the salary, could also be disallowed (although I have rarely encountered this threat).

In the event the C corporation has no retained earnings, the IRS is generally barred from using the dividend trap. However, the very act of IRS disallowance can create retained earnings, as in the following example:

• Assume your C corporation has a retained earnings deficit of $50,000 and that the IRS auditor proposes an unreasonable compensation disallowance of $200,000. That disallowance would increase your retained earnings by $200,000 (ignoring taxes) — resulting in adjusted retained earnings of $150,000 ($200,000-$50,000 deficit). Thus, the IRS auditor can now claim that $150,000 (to the extent of adjusted retained earnings) of the disallowance represents a dividend. Which would result in an IRS bill for the corporate tax on $150,000, plus interest (and possible assertion of a penalty as well).

Comparable Compensation

If the IRS does question the reasonableness of your total compensation, one major defense is evidence of compensation being paid by comparable businesses (which is one of the few guidelines specifically mentioned in that IRS Regulation 1.162). If you can show that a competitor, similar in size and nature to your company, pays as much or more for similar services, you have gone a long way toward defeating the IRS challenge. Unfortunately, where privately owned companies are involved — it’s very difficult to obtain such information from your competitors.

The compensation paid other employees, who are not owners, may also provide you with major IRS ammunition. If you pay yourself $120,000 as president of your company and pay your non-owner vice-president and top salesperson $90,000 or so, your compensation looks right in line. However, if that vice-president (and non-owner) is being paid $60,000 to your $275,000, that’s not too helpful to your position. So raise this defense only if it is advantageous.

Special Qualifications, Abilities and Duties

Here is the area where you can “personalize” your defense. Anything “special” (in the way of talent or position) is a favorable feature, which can earn you the reward of higher (and still “reasonable”) compensation. For example, holding office in a trade association and anything similar, which demonstrates that you are highly regarded in your industry, and even by your competitors, is of help. Similarly: Industry awards, recognition, leadership, innovation, prominence, publicity, accolades, etc. However, the following is considerably more important.

Demonstrating “special abilities” (expertise) in one or more corporate areas, such as finance, marketing/sales, production, product design, distribution, or being an industry innovator, etc. Some executives are really multi-faceted individuals and are also experts at product design, product innovations and even production problems. Companies do pay more for highly talented and/or multi-talented individuals. Keep in mind, once the IRS questions your total compensation, modesty goes out the window and bragging becomes the order of the day!

One special ability would be if you were the founder of the business, the one who built the business and was primarily responsible for the profits, growth and success of the company. Those attributes deserve higher rewards-compensation.

Some sample descriptions of one who deserves greater compensation would be experienced, talented, brilliant, highly qualified, motivator, leader, imaginative, skilled and a wonderful person. Conversely, the fact that your father or father-in-law owns the company does not make you a star — in fact you are more suspect, at least compensation-wise.

Everything helps –– hours worked, education, duties such as serving in more than one capacity (which may save hiring another individual). Remember that the IRS agent generally does not have the slightest idea of your duties, position, function and what you really do for a living. So it’s up to you and your CPA tax advisor lawyer to do a selling job and present your case to the IRS agent. Advance preparation and major documentation are the best overall suggestions.

In two cases that come to mind, the fact that the controlling stockholders developed the business and that their services were regarded as indispensable won the day for their claims of reasonable compensation. Get that: “developed” and “indispensable.” But perhaps if they had been better prepared and they had proven those assertions to the IRS agent, they would not have had to go to Tax Court to win.

Finally, factor in the scope of your business, its complexity and size, the extent and nature of your work and your resultant duties. In some cases, a comparison of your compensation to both the gross and net income of your corporation may be helpful. But, above all, prepare in advance for a potential IRS attack on your total compensation package.

Operating a “Personal Service Corporation”

Sometimes, there is a special defense for service-type companies, because of the “personal service” nature of their business. In general, the courts have been quite generous in reasonable compensation cases involving personal service corporations (e.g., sales reps, doctors, lawyers, accountants, insurance agents, architects, actors, consultants, etc.) and their owners. They seem to agree that the personal efforts of the owner-officer are directly responsible for the earnings of the corporation — and that “invested capital” has little to do with creating or affecting such earnings.

Thus, in many cases, your defense is simply that the personal efforts of the officer-shareholder were the primary and direct cause of the earnings. Therefore, compensation in direct ratio to those earnings (regardless of amount) is not unreasonable. This argument will frequently convince any IRS agent, particularly after he/she studies all those favorable cases on this “service business” point. Said another way, this kind of compensation can usually be justified as reasonable — as long as it does not exceed the gross service fees generated by that individual.

WARNING: The preceding position is far more defensible in the case of a small service business than a larger one. Consider this: In the small service organization, the owner-shareholder is virtually responsible for all the earnings. However, the larger the corporation and the more employees, the less directly responsible that owner is for all the income — and the more he/she is involved in administration, supervision, finance, personnel and other matters that do not directly result in increased earnings for the corporation. In such cases, it is very difficult to prove a direct relationship between the owner’s compensation and the corporate income.

For example, a sales rep, lawyer or CPA with 1-3 employees is in a great defense position, for reasons stated. With 20 or more employees, that argument is considerably weakened. Somewhere in-between those figures probably lies the area where potential IRS disputes can begin. As a practical matter, the IRS is quite aware of the difficulties in attacking personal service corporations, and this challenge will generally be raised only with the larger personal service firms. However, nobody is invulnerable to attack, and the more you know about this problem, the better prepared you can be. It would be just your luck to get some stubborn IRS agent who insists on fighting this out against a 3-person law firm.

One almost foolproof defense is if you have recently incorporated your business. If you then take corporate compensation equal to your earnings in the last unincorporated year, you are about as safe from attack as you ever can be! The logic should be obvious: That’s what you did earn and “pay yourself” when you were not incorporated. Why should you be worth any less just because you now are incorporated? A “killer” argument against the IRS.

A Consistent Bonus Formula

Bonuses should be paid according to a consistent formula that is used year-after-year on the basis of some measurable performance yardstick — rather than arbitrary bonuses based upon annual profits. The formula should be established in advance (most important) and any changes in the formula should be carefully documented in the minutes. In a major case: Mortex Manufacturing Co., Inc. v. Commissioner, there was a long-standing program of paying approximately 30 percent of net sales as total compensation to the entire employee-owner group.

The Court concluded that Mortex had a “reasonable, well-established compensation program that was consistently applied over a period of several years, which tended to show that the compensation was reasonable.” In this case five family members received total annual compensation of about $900,000 and the IRS sought to disallow almost half. The Court upheld all the compensation as reasonable, except about $75,000 over two years.

The Wrong Way to Do It

There are some serious compensation problems that you can create in the manner in which you handle any year-end payments aimed at reducing the company profits.

One of the worst things you can do is to pay year-end bonuses in proportion to the stockholdings of the owners. In other words, the 10 percent owner gets a $10,000 bonus, the 60 percent owner gets a $60,000 bonus and the 30 percent owner gets a $30,000 bonus. In the eyes of the IRS, this represents a clear attempt to distribute profits (which are then considered non-deductible dividends), rather than compensate individuals for services rendered. To reiterate: This virtually establishes those payments as unreasonable compensation, thus non-deductible dividends paid by the corporation. Conversely, if every shareholder received the same (or a fairly similar) dollar bonuses, regardless of the ownership proportion, you have removed this potential attack from the IRS weapon arsenal. So, whatever you do, don’t pay bonuses in the exact ratio of stock ownership — ever!

Another bad mistake is to simply clean out the corporate account with a last minute “bonus,” that almost exactly equals the net profits of the corporation. The IRS frequently views this as an attempt to “drain off profits” and can argue that, therefore, the bonus had little relationship to reasonable compensation, since it was simply calculated to equal the remaining profits of your corporation. This IRS attack is even more damaging if no dividends were paid (more on that later).

As a much safer alternative, consider adopting or amending your corporate retirement plan so that you can increase the fiscal year plan contributions. This represents a better way to reduce the net profits of the average company. So instead of grabbing that last minute “bonus,” let the same funds go into your retirement plan (which will earn income tax-deferred) and the corporation will get the same tax deduction as if you paid that dangerous “bonus” — and save you current individual income taxes as well.

Pension-type retirement plans can frequently be amended, to require a higher contribution than in the past. This, of course, results in a higher income tax deduction and a neater and lower profile way to reduce the profits of small corporations. Of course, as mentioned, this tactic also reduces the total current taxable income of the individuals, who replace a bonus with a larger retirement plan contribution.

If you have a profit-sharing plan (which permits contributions of up to 15 percent of salaries, at the discretion of the company) and have not been paying in the maximum 15 percent contribution, you can simply elect to do so at this time –– or any lesser amount than 15 percent that accomplishes your purpose, at your discretion.

Dividends

A very sophisticated attack that can sometimes be launched by an IRS agent is that if your company does not pay any dividends, ergo, some portion of your compensation is (impliedly) a return on your invested capital, and thus represents a “dividend.” The danger being of course (as previously explained), that a dividend is not deductible by your corporation, while compensation, of course, is. This, then, is another attempt to disallow part of your salary, even when your total compensation is reasonable.

After many, many court cases, the IRS backed down on their automatic presumption that any time a corporation does not pay any dividends, then part of the owner’s compensation must include a dividend by implication (their changed position is memorialized in IRS Revenue Ruling #79-8).

However, the payment of dividends, even if quite small, is absolutely recommended. In almost every case where the IRS does raise the unreasonable compensation issue, their report always ends with, “…and furthermore, the company has never paid any dividends.” Also, keep in mind that if your company has a small initial capitalization, a small dividend can represent a high percentage return. For example, if you originally started your company with a $10,000 stock issue, a $1,000 dividend represents a 10 percent annual return. And the tax you pay on that $1,000 is cheap insurance that negates this part of an IRS attack.

TAXTIP: However, if you have no “retained earnings,” the necessity to pay dividends disappears. This situation occurs when the corporation has incurred losses in prior years that exceed the net profits of other prior years. The 50 percent entertainment disallowance, non-deductible life insurance premiums and certain other items also reduce retained earnings. Since dividends are paid out of retained earnings, if you don’t have any — you cannot pay dividends (in fact it is illegal to do so in most states).

CAVEAT: See earlier example about how retained earnings can be created by the disallowance itself.

Corporate Minutes

From time to time, we have had an IRS agent state that the corporate minutes of a small business were “self-serving,” since the owner could control exactly what they said. Even so, the courts frequently give great weight and credence to such minutes. Don’t ever forget: Self-serving or not, they are the only minutes that exist (i.e., “the only game in town”). If you don’t take advantage of them, you are throwing away a great opportunity to defend reasonable compensation (and your dividend policies). You have nothing whatsoever to lose but a little time and care.

IRS agents usually ask to see the corporate minutes first (when beginning an audit); and the contents of those minutes can “set the tone” and be essential to the eventual outcome of the audit. If you throw away a major advantage that is yours for the taking, you deserve what then follows!

From the IRS Audit Techniques Handbook: “The time of year when compensation is set…establishment of compensation toward the end of the year is sometimes an indication that…an element of profit distribution (i.e., “dividend”) is involved.” So “front-end planning” is essential. To help protect you, here are my suggested (and essential) instructions:

• Always set your annual salary in the corporate minutes.
• Always do so at the beginning of each fiscal year.
• Always set your annual salary high enough to include any possible year-end bonus, or back salary, etc. If you set it high and don’t reach the stated amount, so what? It was a tough year and you didn’t make it. But if you have a great year, the money was pre-approved and is safely yours for the taking. (Now don’t get crazy and vote yourself 50 times any possible annual salary — tailor it, reasonably and to the circumstances.)
• Include annually, all information relating to past salaries and how low they have been (to conserve working capital, to expand the business, etc.). Then explain how, in effect, these represent accrued past salaries, with the totals growing larger and larger every year — and that someday the company will pay them. Window dress for the day a huge salary is indeed paid! (Also, see the next section of this article.)
• Recite in the minutes all reasons and circumstances leading to any current increase in your compensation.
• Avoid any appearance of trying to match your compensation to the net profits of the corporation. (This problem is generally avoided by setting compensation at the beginning of the year, i.e., ”front-end planning.”)
• Always maintain annual (at least) and formal corporate minutes, for reasons stated. This can be a dangerous and expensive place to get lazy, even though I am quite aware that every small businessperson hates “paperwork” and paying legal fees, but this one is essential. DO IT!

Prior Compensation

If applicable, in this area you can launch a major and perhaps devastating attack or counter-attack on any IRS challenge of unreasonable compensation. You have the right to measure reasonableness of compensation over the whole period of your employment — and not just over a single (current) year! This idea can represent a great defense, if your present (high) salary is intended to compensate you for the low salaries of earlier years. If so (as already suggested), document those facts in your corporate minutes, preferably in every year of low salaries.

In this case, the position is simply that your current compensation is intended to make up for prior (and underpaid) salaries, as well as for current services. You are playing “catch up.” All you need, I remind you again, is outstanding documentation.

Hedge Agreements (Pay-back Agreements)

These agreements have nothing to do with farming. They have to do with “hedging” the possibility of an IRS disallowance. The two major areas where hedge agreements are often used are (1) compensation agreements and, (2) expense accounts. The act of the IRS disallowing part of your compensation as “unreasonable” can (as you have learned) convert a corporate tax-deduction for salary into a non-deductible dividend. A hedge agreement requires that the employee repay any portion of the salary disallowed as unreasonable (and/or any portion of expenses disallowed as “unsubstantiated”). What does this accomplish? A major tax deduction for the individual, since the repayment of the salary (or expenses) under a legally binding corporate resolution results in an individual income tax deduction in that year under IRC Sec. 162 (Revenue Ruling 69-115).

Well then, why doesn’t every business in America use hedge agreements? Because of IRS “Catch 22” philosophy: The IRS frequently considers the very fact that a hedge agreement exists, as evidence that you are indeed aware that your compensation (or some expense) really is unreasonable! So, you then “hoist yourself on your own petard,” which can really hurt.

Many tax attorneys and CPAs believe (with ample justification in many cases) that the hedge agreement increases the risk of your compensation (or expenses) being disallowed. Others, while recognizing the danger, say, “Forget it — just sign the hedge agreement and, ‘We will fight them in the hedgerows, and we will fight them in the bushes.’” (That’s a WW II Normandy invasion quote, for those too young to remember.) I personally think the hedge agreement is rather dangerous, but I just call it to everyone’s attention for the record. Discuss it with your own tax advisor and then decide.

The 5-Factor Approach

In the Mortex Manufacturing Co. case discussed earlier, the Tax Court used this approach in their compensation decision:

• Specific considerations regarding the owners-employees: the role of the shareholder-employees, i.e., special qualifications and abilities.
• Internal consistency in establishing compensation levels: i.e., a consistent bonus formula.
• Comparable compensation levels of other businesses: similar compensation in similar industries for similar services.
• Character and condition of the corporation: i.e., the nature and financial condition and progress of the company; its size, complexity of the business, etc..
• Tax motivation in setting compensation levels — whether compensation was paid pursuant to a structured, consistently applied program: not disguised dividends; not arbitrary bonuses, if some dividends were paid, if there is an adequate return on investment.

In a more recent case (Leonard Pipeline Contractors, Ltd. — Tax Court Memo 1998-315), a somewhat different (and somewhat similar) set of 5 factors were used to determine reasonableness:

• Employee’s role in the company.
• Comparison of compensation paid the employee with that paid similarly situated employees in similar companies.
• The character and condition of the company.
• Disguised dividend payments as additional compensation. The Court questioned whether a conflict of interest existed that might encourage the company to do so.
• Whether the compensation was paid under a structured, formal and consistently applied program.

COMMENT: If you will reread the earlier sections of this article, you will find my comments that cover each of these 5 points raised by the Tax Court in this case.

S Corporations

This is a special kind of corporation that is essentially treated like a partnership for federal income tax purposes. It usually pays no federal income taxes, since all taxable income “flows through” to the shareholders of the S corporation. Electing to be treated as an S-corporation will instantly eliminate all questions regarding reasonable compensation (from the applicable year and forward — not for prior years).

To remind you of the principal uses of S-corporations:

• To avoid any challenge of unreasonable compensation (interestingly, you can be challenged by the IRS if your S corporation salary is too low — since this is frequently done to avoid payment of payroll taxes on salaries).
• If there is a problem with “excess retained earnings,” over the $250,000 safe-harbor amount. The S corporation election prevents any such further accumulations, since all future earnings are distributed to the shareholders.
• If your company is in a loss situation and that loss is better deducted on the personal tax return of the owner, rather than at the corporate level.
• To avoid being forced to accrual basis reporting. If you have a personal service corporation and the gross income exceeds $5 million annually.
• To avoid the flat 20 percent alternative minimum tax (AMT) for corporations, which can be levied (after a $40,000 exemption) on such items as: corporate life insurance proceeds; and/or 75 percent of the excess of “book” income over taxable income; plus municipal bond interest; all dividends received; and a number of other “preferences.”

So the S corporation election represents one perfect solution to the unreasonable compensation problem, if the price is worth it. You and your tax advisor can decide. In our practice, we are using it more and more in the special case of very high compensation paid to the owners of small business corporations of all kinds.

Special S Corporation TAXTIP

If you do elect to go S-corporation, do not reduce your salary level for the next three years! If you do so, an IRS agent could use that as proof that your prior compensation was indeed unreasonable (e.g., as a C corporation you took a $400,000 salary, but now as an S corporation, you are only taking $60,000). After three years, when the IRS audit statute of limitations has expired (but still with expert advice) — you can do as you please.

Selected Cases

As explained near the beginning, court cases have really defined and refined the vague IRS guidelines. Here are a few significant ones, both good and bad, from which to gain some great insights. The second case is a classic victory for the taxpayers, including almost every element we have discussed, while the first case is almost the reverse.

• Only$650,000 to $850,000 allowed of $709,000 to $1,158,000 in compensation: The 75 percent shareholder-CEO also continued to make sales calls and supervised the sales team. There was no formal bonus program and bonuses were determined after the end of the fiscal year. The company never paid dividends in its entire history and the Tax Court said that fact was “relevant to their analysis” — and also the fact that bonuses were determined after the end of the fiscal year “cast some doubt as to whether such payments were compensation,” as well as the fact there was no formal bonus program (Tric Metals & Services, Inc. — Tax Court Memo 1997-360).
• $2.92 million upheld in full: Two shareholder-employees performed multiple duties, had been undercompensated in prior years, developed unique business strategies, were responsible for great success and rapid growth in a highly competitive industry, dividends were paid, retained earnings still increased substantially after bonuses, and they had exceptional qualifications. The IRS tried to limit the total deductions to $598,000 (Pulsar Components International, Inc. — Tax Court Memo 1996-129).
• Only $662,000 of $1,259,000 allowed: No evidence that the compensation was to make up for prior years’ of undercompensation, bonus wiped out all earnings for the year, one-man business and founder (Donald Palmer Co., Inc. — Tax Court Memo 69-1869).
• $1 million salary upheld in full: A masonry contractor earned a reputation for quality work, saved the company when the recession hit, worked 15-hour days, courted big developers, was CEO and CFO and marketing director (Ginger Masonry — Tax Court Memo 1997-251).
• Only $300,000 to $350,000 allowed — of $700,000 to $900,000 in compensation: Court agreed with the IRS that compensation was unreasonable, despite finding that the president-founder-95 percent shareholder was instrumental in the company’s success (Rapco, Inc. — Tax Court Memo 1995-128, and upheld by 2nd Circuit Court of Appeals).
• $1 million salary upheld in full: The CEO of this construction company began the business in his basement, worked 16-hour days and 7-day weeks, took low pay, revenues rose 1,600 percent to $26 million; retained earnings and return on equity both had huge increases. In that last year he took a $1 million salary, the IRS denied part of the compensation, and the court approved it in full (Choate Construction — Tax Court Memo 1997-495).
• $353,000 to $478,000 salaries upheld in full: Bonus policy was consistent from year-to-year, hard work and innovative ideas, no pension plan, few other perks, no dividends paid. The Court defined “reasonable” as, “the intrinsic value of employees in the broadest and most comprehensive sense.” (Mad Auto Wrecking, Inc. — Tax Court Memo 1994-110).
• $703,530 to $882,680 allowed — of $1,000,000 to $1,815,930 in compensation: Court allowed the sole shareholder the maximum salary found in an industry compensation study and noted that no dividends were ever paid (Guy Schoenecker, Inc. — Tax Court Memo 1995-539).
• $683,368 salary upheld in full: Much of the salary was to make up for much lower compensation in prior years (the year before the salary was $86,055). The owner-employee filled both managerial and technical roles, developed patented technology for the company and made the company an increasing success (Comtec Systems, Inc. — Tax Court Memo 69-1581).
• $817,500 salary upheld in full: The owner-employee performed complex and wide-ranging duties. Company bonus plan was designed by their CPA and consistently applied. Some non-owners received more under the plan than some shareholders. The company paid nominal dividends (BOCA Construction, Inc. — Tax Court Memo 69-1581).
• $400,000 of $1.68 million bonus allowed: The $400,000 was considered as compensation for past services. However, the Tax Court remained convinced that the $1,777,800 total paid the taxpayer was determined to a large extent by the amount he was required to pay his wife in connection with their divorce settlement. (Leonard Pipeline Contractors, Ltd. — Tax Court Memo 1998-315). NOTE: See earlier reference to this case.

CAUTION: All these cases illustrate partial or full victories for the taxpayers. There are hundreds of cases where the taxpayers lost completely — and the IRS disallowances were upheld in full.

Conclusion

Follow all these rules and suggestions — and keep in mind the following key points we have discussed:

• The importance of minutes — at the beginning of the year (front-end planning).
• Memorialize prior under-compensation, including accrued amounts, annually.
• Use a consistently applied formal compensation policy.
• If possible, pay dividends (small ones are better than none — large ones are better still).
• Assemble all available information on comparable compensation.
• Delineate all special qualifications, abilities and duties of the owners-employees, i.e. document the rationale behind the compensation. Mention every extraordinary contribution to the company’s success, and the size and complexity of the job.
• Try to use objective third parties to determine compensation, e.g., a compensation consultant or CPA.
• Do not link compensation to stock ownership, or as a tool to erase all corporate profits.
• Keep in mind that it’s easier to defend a steady growth in compensation than one huge, explosive increase in compensation in one year (e.g., the Comtec case cited earlier).
• Remember the special protection for many service businesses.
• Consider an S corporation election for absolute protection in future years!

By all means save this information for the future! Hopefully, if challenged, you will win — and hopefully, this information will then help you to do so.