Reasonable/Replacement compensation is a contentious issue that may require testimony from an expert witness. It may, for example, become a sticking point in shareholder disputes, divorces and IRS inquiries.
What's "reasonable" is subjective — especially when related party employees are involved. But the issue may be clarified by applying the so-called independent investor test. A recent U.S. Tax Court case sheds light on the factors that may be considered when estimating reasonable compensation. (H. W. Johnson, Inc. v. Commissioner T.C. Memo. 2016-95)
Foundation of the Case
H.W. Johnson is one of the largest curb, gutter and sidewalk contractors in Arizona. The IRS issued deficiency notices for compensation paid in 2003 and 2004 to two minority shareholders, who were also the sons of the company's majority shareholder.
Since 1993, the sons managed all aspects of the business, and each owned 24.5% of the company's stock. Their mother retained 51% of the stock. Operations were split into two geographical divisions, eastern and western, with each brother managing a division's operations, including:
- Contract bidding and negotiation,
- Project scheduling and management,
- Equipment purchase and modification,
- Personnel management, and
- Customer relations.
Each son supervised over 100 employees and worked 10 to 12 hours a day, five to six days a week. The sons were readily available if problems at a job site arose and were known in the local industry for their responsive, hands-on management style. As a result, the company was routinely awarded contracts even where it was not the lowest bidder.
The company collected contract revenues of more than $23 million in 2003 and $38 million in 2004. The following table summarizes the compensation — including salaries, bonuses and director's fees — that was paid to the sons during the time period in question:
The IRS claimed these amounts exceeded "reasonable compensation" and originally issued a notice of deficiency that disallowed $2,607,517 and $5,616,771 of the deductions for 2003 and 2004, respectively. The IRS eventually backed down, conceding that H.W. Johnson's total compensation deductions exceeded what's reasonable by $811,039 and $768,916 for 2003 and 2004, respectively.
The Internal Revenue Code lets a taxpayer deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered" as an ordinary and necessary business expense. A taxpayer is entitled to a deduction for compensation payments if the payments are reasonable in amount and paid purely for services rendered.
To help defend their positions, both parties in H.W. Johnson hired financial expert witnesses. The Tax Court framed its analysis of reasonable compensation using the following five-factor approach:
1. Role in the company. This factor focuses on the employee's importance to the success of the business. Courts will consider the individual's position, duties performed and hours worked.
In this case, the Tax Court decided that this factor helped support the company's position. Both sons were integral to the company's success. Under their management, annual contract revenues increased dramatically, from approximately $4 million in 1993 to over $38 million in 2004. Both sons also personally guaranteed the company's debt.
2. External comparison. This factor compares the employee's compensation to what similar companies pay unrelated parties for performing similar services.
In the case at hand, the company's performance far exceeded any of the comparable companies that were identified. This made it hard for the experts to make meaningful comparisons. So, the Tax Court didn't side with either party on this factor.
3. Character and condition of the company. This factor focuses on size (as measured by revenue, net income or capital value), complexities of the business and general economic conditions.
Again, the court decided that this factor helped support the company's position. H.W. Johnson experienced "substantial success" during the years at issue, in terms of revenue, profit margins (before officer compensation) and asset growth.
4. Internal consistency of compensation. This factor focuses on whether the compensation was paid pursuant to a structured, formal and consistently applied program. Subjective or erratic bonus payments or payments that violate company policy may be suspect.
The Tax Court ruled that this factor also worked in the company's favor, because it had consistently adhered to its structured officer bonus formula from its inception in 1991.
5. Conflicts of interest. This factor considers whether a relationship exists between the company and the employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation. Such a relationship may exist when an employee is the company's controlling shareholder or a member of the controlling shareholder's family. Here's where the independent investor test comes into play.
Spotlight on ROE
The focus of the independent investor test is essentially whether a hypothetical investor would receive a reasonable return on equity (ROE) after payment of the compensation. If the company's ROE would satisfy an independent investor, there's a strong indication that the employee's compensation is reasonable and the payments aren't disguised distributions.
The fifth factor, conflicts of interest, was the main point of contention in this case. Although the experts agreed that the company's ROE was 10.2% and 9% for 2003 and 2004, respectively, they disagreed about the ROE that would satisfy an independent investor.
The IRS's expert concluded that investors would expect to receive a ROE ranging from 13.8% to 18.3%, based on various external sources. But the Tax Court concluded that these sources weren't necessarily comparable to H.W. Johnson in terms of industry, business operations, size and financial performance.
The court found the analysis prepared by the company's expert to be more persuasive. He used ROE figures compiled by Integra Information for 33 companies falling under Standard Industrial Classification code 1771, Construction — Special Trade Contractors — Concrete Work, with sales ranging from $25 million to $49,999,999. The average ROE from these comparables was 10.5% and 10.9% for 2003 and 2004, respectively. H.W. Johnson's actual ROE was only 0.3 percentage points below the average in 2003 and 1.9 percentage points below the average in 2004.
Based on the independent investor test performed by the company's expert, the Tax Court ruled that the compensation the company paid to its minority owners was, indeed, reasonable. The court also determined that a company needn't exceed the industry average ROE to satisfy the independent investor test — the return just needs to be in line with the industry average.
Tax Court's court opinion also states, "In applying the independent investor test the courts have typically found that a [ROE] of at least 10% tends to indicate that an independent investor would be satisfied and thus payment of compensation that leaves that rate of return for the investor is reasonable." The 10% benchmark, after taking owners' compensation into account, may serve as a general rule of thumb for companies to apply when determining whether compensation is reasonable, though the exact percentage may vary depending on the facts and circumstance of a particular case.
This case does more than highlight five factors to consider when determining reasonable compensation. It sheds light on how the independent investor test works and how critical it is to select a sample of comparables that mirror the company in terms of industry, business operations, size and financial performance when estimating a range of expected ROE.
Note that this analysis is company driven and does not focus on the abilities, skills and experience of the employee/owner. The relevant question is “what would the company pay,” and not “what is the employee worth?”If you're faced with questions regarding what level of compensation is reasonable — in a tax situation or for other purposes — contact a financial professional. He or she can provide an objective analysis of the five factors presented in this case.
DOUGLAS P. SOSNOWSKI, CPA/ABV, ASA, CFF
Douglas P. Sosnowski provides business valuation, forensic accounting, and litigation support services for Brisbane Consulting Group. He has extensive valuation experience and has served as an expert witness, testifying in courts of law throughout the state of New York. Doug has experience consulting with publicly traded entities and valuing a variety of closely held companies in connection with mergers, acquisition and divestitures, business combinations, estate and gift tax planning, ESOPs and purchase price allocations. He also has experience in the quantification of lost income in determining business interruption claims for insurance adjusters. Doug is a member of the American Institute of Certified Public Accountants, New York State Society of Certified Public Accountants and the American Society of Appraisers. Doug is a licensed financial advisor holding Series 7 and 66 securities licenses. He graduated with honors from the State University of New York at Buffalo earning his Bachelor of Science degree in business administration with concentrations in accounting and finance.