The Disguised Dividend for Owner-Employees

The corporation can be viewed from a number of different perspectives. One way is to view it as a group of people coming together to perform some business activity, with each having different relationships and risks in the arrangement.

The role any one individual plays in the corporation may not be clearly defined. The owner-employee provides an example. On the one hand, the owner-employee may be the only investor or primary investor, they may be the person who takes some or all of the financial risk, and they may also be the person who performs services for the business or, in some cases, adds the most value by performing services.

This complex relationship makes it difficult to apply concepts such as “reasonable compensation” for the owner-employee. This can lead to disputes with the IRS over whether compensation to the owner-employee is “reasonable.”

The Clary Hood, Inc. v. Commissioner, No. 22-1573 (4th Cir. 2023) case provides an opportunity to consider this issue in the context of the disguised dividend for C corporations.

Facts & Procedural History

The taxpayer is a C corporation. The corporation was in the land excavation and grading business. It had $44 million in revenue in 2015 and $69 million in 2016.

The revenues increased significantly due to the efforts and direction of the CEO. The CFO had decided that the CEO was underpaid for several years. Thus, the CFO and the taxpayer’s tax advisors evaluated the issue and concluded that the CEO should be paid a bonus in the current years to make up for the prior year’s underpayments.

The tax dispute involved the $5 million bonus it paid to its CEO in 2015 and 2016. The corporation deducted the bonuses as wages. On audit by the IRS, the IRS determined that the bonuses were actually disguised dividends. It reversed a part of the deduction for the bonuses and imposed penalties on the ensuing income tax.

The taxpayer filed suit in the U.S. Tax Court. The court determined that the taxpayer could deduct $3.7 million for 2015 and $1.4 million for 2016 as reasonable amounts for total compensation to its CEO, which lead to the current appeal.

About Disguised Dividends

Section 162 allows a deduction for ordinary and necessary business expenses. This is the same tax code section that applies to most tax deductions absent some more specific section or limitation. It is used by individuals, estates, trusts, and even corporations.

There are a number of disputes involving Section 162, such as whether the expense is ordinary and necessary and whether the expense is adequately substantiated. When it comes to C corporations, like the taxpayer in this case, the IRS can also question whether the amount is reasonable or a disguised dividend (which is different than a “disguised sale” of a business interest).

A disguised dividend, sometimes also referred to as a “deemed” or “constructive” dividend, is a payment made by a corporation to its shareholders that is dressed up to appear as a different form of transaction, usually an expense, to take advantage of more favorable tax treatment.

The term “disguised” refers to the strategy used by corporations to make certain distributions appear as legitimate, deductible business expenses instead of taxable dividends. For instance, excessive salaries, bonuses, or loans to shareholders can be classified as disguised dividends if they’re not in line with what would be considered reasonable for the services provided.

The reason why disguised dividends are an issue is that the C corporation is able to deduct wages paid to employees, including wages paid to the CEO and owner. The C corporation cannot deduct amounts that are dividends paid to the owner. Thus, the C corporation pays tax with no deduction for the amount paid to the owner–there is a corporate-level tax–and then the owner picks up the dividend income on his or her personal income tax return and pays tax on his or her individual income tax returns. This double tax is what taxpayers may seek to avoid and what the IRS, on audit, may seek to impose.

This concept does not necessarily apply in the case of S corporations or partnerships. The S corporation deducts wages paid to the owner, as with the C corporation, but the net profit then flows through to the S corporation’s owner’s personal income tax returns. Thus, the owner picks up the wage income on their personal income tax return and the flow through income too. The S corporation owner isn’t necessarily incentivized to maximize their wage payments. They might try to do just the opposite to avoid payroll taxes on the wage portion of their earnings.

Compensation for Ownership vs. Services

That brings us back to this case. In this case, the question is what standard should apply when determining whether a bonus paid to the owner of a C corporation is a disguised dividend.

To grasp this concept, it’s necessary to comprehend the reasons a corporation compensates its owner-employee. Compensation can be given for the capital invested and ownership stake held by the owner-employee, essentially rewarding them for the financial risk they’ve taken. The owner can also be paid for their contribution of skills, effort, or time dedicated to the business operations. This is a form of opportunity cost, as time is a finite resource and the owner is choosing to dedicate it to the business rather than other potential pursuits. It is also a form of reward for activities or the application of knowledge.

Whether compensation is reasonable is usually a decision as to whether compensation is being paid for capital investment/ownership vs. services. The facts of the individual case and activities performed by the owner-employee can result in different outcomes.

What is Reasonable Compensation?

This has led to a “reasonableness” standard that applies in evaluating if compensation, like a bonus, is actually a disguised dividend.

Section 162(a) stipulates that executive compensation is deductible as a business expense if it is:

1. Reasonable in sum, and
2. For services actually performed.

In order for shareholder/employee compensation to be classified as employee compensation, Treasury Regulation 1.162.7 outlines four prerequisites. Compensation for owner-employees should:

1. Be an ordinary and necessary expense,
2. Be reasonable in amount,
3. Be for services actually rendered, and
4. Be genuinely paid or incurred by the taxpayer corporation.

Per Regulation 1.162-7, a taxpayer corporation may deduct owner-employee compensation that is performance-based using a percentage formula. Compensation for owner-employees based on a percentage formula could be:

1. A percentage of corporation revenue,
2. A percentage of corporation earnings, or
3. A percentage of some other corporate income measure.

Besides the Treasury Regulations regarding the reasonableness of owner-employee compensation, taxpayer companies can also refer to judicial precedents that assess the reasonableness of compensation.

Determining what constitutes reasonable compensation can be complex, as it often depends on a multitude of factors. Generally, “reasonable compensation” is the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Here are some of the key considerations often used to determine if compensation is reasonable:

1. The employee’s qualifications: This includes the employee’s skills, experience, education, and professional credentials. More qualified individuals are often justifiably compensated more highly.
2. The nature, extent, and scope of the employee’s work: This pertains to the job’s responsibilities, complexity, and the time commitment it requires. More demanding roles usually warrant higher compensation.
3. The size and complexities of the employer’s business: Larger and more complex businesses often require more from their executives, which may justify higher compensation.
4. A comparison of salaries paid with the employer’s gross and net income: Compensation should be proportionate to the company’s income. If a significant portion of the company’s income goes to executive compensation, it may be seen as unreasonable.
5. The prevailing general economic conditions and the background of the industry: Compensation can be influenced by the state of the economy and industry standards. For example, some industries typically pay more than others.
6. A comparison of salaries with distributions to officers and retained earnings and the employer’s dividend history: If executives are receiving more in salary than the business retains or pays out to shareholders, it could signal unreasonably high compensation.
7. The prevailing rates of compensation for comparable positions in comparable concerns: Comparing compensation with similar roles in the industry can help determine what’s reasonable.
8. The salary policy of the employer as to all employees: Policies that apply consistently to all employees may help justify a particular level of compensation.
9. The amount of compensation paid to the particular employee in previous years: Increases in compensation should be proportional and justified by increased responsibilities or company growth.
10. The employer’s financial condition: A company in poor financial health may not reasonably be able to afford high compensation.
11. Whether the employer and employee dealt at arm’s length: Relationships that could influence compensation decisions, such as family ties, may call into question the reasonableness of the compensation.
12. Whether the employee guaranteed the employer’s debt: If the employee is financially responsible for the company’s debt, higher compensation may be justifiable.
13. Whether the employer offered a pension plan or profit sharing plan to its employees: These benefits can add to the total compensation package and may need to be factored into the reasonableness assessment.
14. Whether the employee was reimbursed by the employer for business expenses that the employee paid personally: This could affect the total value of the compensation received by the employee.

These factors are often considered together, and no single factor is typically decisive. It is also important to document the reasons for the compensation level to provide support in case of an audit by the IRS.

There are court cases that apply these factors and they have not done so consistently.

On appeal, the taxpayer’s argument, in this case, was whether the tax court erred in applying a multifactor test. The taxpayer argued for an “independent investor” test and a rebuttable presumption that an executive’s compensation is reasonable if the corporation’s shareholders are receiving a sufficiently high rate of return on their equity investment. 

The appeals court did not agree. It upheld the multifactor test that looks at the investor and the service factors.

The Takeaway

The IRS scrutinizes payments to owner-employees of C corporations to ensure they are not simply attempting to reduce the corporation’s tax liability. If the IRS deems certain payments as disguised dividends, it can result in additional taxes and penalties for the corporation. Thus, the corporation cannot simply pay the owner-employee wages or other compensation to avoid paying dividends. This puts the corporation in the position of the IRS reclassifying the compensation as a dividend, as in this case. With that said, there are other options for compensating the owner-employee that can avoid this situation. This is where effective tax planning can help.