Reasonable Compensation
A Court of Appeals recently reversed a Tax Court holding involving reasonable compensation to a key stockholder/employee of a privately held corporation. In many situations, a high salary can be justified by having special expertise to operate the business. In the present situation, the Court of Appeals stated that reasonable compensation should also take into consideration prior years of being undercompensated by the company. In the case at issue, the corporation’s gross revenue increased tremendously over the past several years. However, only recently did the stockholder/employee begin to receive compensation.
The stockholder actually took out 4.4 million dollars in compensation in one year. Obviously, the IRS, as well as the Tax Court, held that such compensation was unrealistic and unreasonable.
The Court of Appeals stated that the individual, being the only stockholder of the corporation, had worked long and hard to get to a point where he could receive a lot of money. Accordingly, the amount of compensation i.e. 4.4 million dollars represented the amount needed to remedy many prior years of being undercompensated in building the business. Thus, the Court of Appeals ruled that the salary paid to the sole stockholder was not unreasonable.
Editorial Comments
This case is fantastic for anyone involved in trying to build a business. In many situations, individuals start a business and rely on savings, as well as a spouse’s income, to be able to put their business on its feet. The Appeals Court clearly stated that, as long as an individual worked hard and was undercompensated in the past, there was nothing wrong with receiving a large salary in one year (in the present case 4.4 million dollars) to make up for the years of being undercompensated.
By: Basi & Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors