Deduction for compensation of closely held corporation's shareholder-employee reduced, but no accuracy related penalty
In this case, Multi-Pack Corporation (the "taxpayer"), a closely-held corporation, paid its sole shareholder compensation in the amount of $2,020,000 in 2002, and $2,058,000 in 2003. The shareholder served as the taxpayer's president, CEO, and COO, controlled all aspects of taxpayer's operations, and performed all managerial duties. The IRS determined in a notice of deficiency that the taxpayer may only deduct compensation in the amount of $655,000 and $660,000 in 2002 and 2003, respectively. The IRS also imposed 20 percent accuracy-related penalties for negligence and intentional disregard of rules and regulations under Section 6662(c).
Deduction allowed only to extent compensation is reasonable
The Tax Court first addressed the issue of whether the salary paid to the sole-shareholder was reasonable. The Court recognized that careful scrutiny is necessary to analyze reasonableness of compensation paid to a shareholder-employee of closely-held corporation in order to ensure that it is compensation and not a disguised non-deductible dividend, because there is not an arm's length dealing. IRC Section 162(a)(1) and Treas. Reg. §1.162-7(a) permit a deduction for compensation as an ordinary and necessary business expense if: (i) the amount of the compensation is reasonable and (ii) the payments are in fact solely for services. The Circuit Courts of Appeals use various approaches in tackling the issue as to whether the amount of the compensation is reasonable.
The multi-factors hypothetical independent investor test
Since this case is appealable to the Ninth Circuit, the Tax Court applied the five factor test set forth in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983). In evaluating reasonableness, the Court considered the following factors from the point of view of a hypothetical independent investor, with no single factor being decisive on the question: (1) the employee's role in the company, (2) external comparison of compensation to that paid by similar companies, (3) character and condition of company, (4) conflict of interest, and (5) internal consistency of compensation.
The Court concluded that based on the five factors, the shareholder-employee's compensation was reasonable in 2002. However, the Court determined that the compensation should be reduced from the $2,058,000 reported on the taxpayer's 2003 Form 1120 to 1,284,104, because an independent investor would expect a lower compensation as a result of a decline in revenues in 2003.
Accuracy related penalties and the reasonable cause exception
The Tax Court determined that taxpayer's compensation deduction for 2002 was reasonable, and as a result that it only had to address accuracy related penalties for the 2003 tax year. The Court held that the taxpayer was not liable for the 20 percent accuracy-related penalty for negligent or intentional disregard of rules and regulations because the Section 6664(c) and Treas. Reg. §1.6664-4 reasonable cause exception applied. The Court, citing United States v. Boyle, 469 U.S. 241 (1985), stated that a taxpayer can establish reasonable cause by showing that it exercised ordinary care and business prudence, and that reliance on an independent and competent professional may meet this requirement.
The Court stated that in order for a taxpayer to establish the reasonable cause and good faith defense by relying on advice of a tax professional to avoid a liability for a Section 6662(a) penalty, three requirements must be met: (1) the advisor must be competent and have sufficient expertise to justify reliance; (2) the taxpayer must have provided the advisor with necessary and accurate information; and (3) the taxpayer must have relied in good faith on the advisor's judgment. The Court concluded that the taxpayer met each of these three requirements for 2003, and that accuracy related penalties shall not apply.