The EMCO/Hanover Group Blog

The IRS is challenging in court the salaries of some executives who own their companies. But such cases aren’t always airtight. Here are some surefire strategies to turn back the tax man.

Guess who’s coming to dinner? It’s the Internal Revenue Service, and amid lean times, the agency has worked up a powerful appetite. A courteous house-guest, the IRS will do the cooking. Unfortunately, its specialty is barbecue, and if the agency thinks you’re making too much money, you may find yourself turning on a spit.

Translation: The IRS is taking a harder look at ways to generate tax dollars. Executive/owner compensation is one of the many areas under scrutiny. If you are not a sub Chapter S corporation, and your executive team’s compensation exceeds 6 percent of sales, you might be waving a red flag. You also could be in jeopardy if you have not been retaining enough profits and/or paying sufficient dividends.

If you fall into either of these categories, read on. But if you’re called on the carpet, don’t despair. There are several ways to turn back the tax man. At The EMCO/Hanover Group, we maintain, for example, that compensation is reasonable if it is comparable with returns an independent investor might demand.

BREACHING THE “HOT ZONE”

EMCO/Hanover became involved with a California-based company, a distributor of construction-related materials, that came before the U.S. Tax Court. The company was formed in 1977 from scratch with minimal capital by two shareholder/employees. They identified and exploited a profitable market niche not being served by competitors. Uneducated in business and computer science, they took courses in business law, computer operation and programming, and other relevant subjects. They handled all executive and management tasks themselves–including heavy manual labor and personnel training–and even computerized their business ahead of many competitors, personally installing cables, hardware, and programs. Typically they worked up to 20 hours per day, often sleeping on the floor to be ready to load shipments early the next day.

Because of their efforts and abilities, the business grew rapidly. At the end of the 1989 fiscal year, it had 36 employees and had grossed almost $12 million. Its profit margin of 30 percent handily topped the 22 percent figure of its nearest competitor.

For each of the three years in question, the company’s founder/executives received compensation equivalent to about 13 percent of sales. A fair exchange, you might think, for one’s sweat and blood. But the IRS thought otherwise, maintaining the pay exceeded the 6 percent figure the government first looks at. In fact, 13 percent even exceeds the IRS’ “hot zone” guideline of 10 percent.

Unfortunately, the company’s financial advisers should not have waited until calendar year 1991 to switch this company to a sub S status. If that had been done for the three years in question, the company could have saved in excess of the $300,000 which it already has spent defending itself. And the trial has not yet begun.

This is not a fraud case either, because nothing was hidden from the IRS. However, it can involve upward of $3 million, subject to taxes, in penalties and interest, given that the IRS has said excess compensation is approximately $1 million per year. At present, there are three years in question, with an additional three years pending.

BUILDING A DEFENSE

Let’s examine how one might defend these entrepreneurs. The IRS has determined that “reasonable compensation” consists of three key elements: Payments must be purely for services rendered; it is an ultimate question of fact of the case involved (and each case turns on its own facts and circumstances); and there is no single standard to decide the question.

As such, the Tax Court interprets “reasonable” under the following eight standards of the Internal Revenue Code:

* an employee’s qualifications;

* the nature, extent, and scope of the employee’s work;

* the size and complexities of the business;

* a comparison with competitors’ gross and net incomes;

* the prevailing economic conditions;

* a comparison of salaries with distributions to stockholders;

* prevailing rates of compensation for comparable positions at comparable concerns;

* the compensation policy of the taxpayer for all employees.

When the IRS reviewed the company’s executive compensation, it automatically deemed it to be excessive. However, the IRS did not consider several basic facts.

First, survey data were used for comparative purposes. This information was not comparable because it was neither geographically nor industry-specific. No reference was made to economic conditions at the time, to the status of the industry itself, or to the wage differential, which is typically much higher for California-based executives than for their counterparts outside the state.

In addition, information gleaned from surveys is typically “volunteered” and is often unreliable unless the survey sample can be verified. Those companies that deem themselves to have high executive compensation usually will not respond to surveys, inflating the margin of error in the data.

In this case, the IRS expert’s report made no mention of local direct competitors whose executive/owners themselves never responded to the survey in question. Further, no comparison was made to actual compensation paid to competitive executives. Nor was reference made to the eight standards of reasonable compensation. The IRS also failed to compare the entrepreneurs’ compensation to actual compensation paid in relation to revenue, a prime IRS valuation method, or to “real hours” worked. (Remember, these executives kept personnel costs low by performing many functions themselves.)

WHAT IS “FAIR” COMPENSATION?

Typically, IRS experts have impressive theoretical credentials, but they lack “real world” executive management experience. As a result, they often are unable to correlate the needs of the job with the size of the business when arguing a case in court.

In the case of the California company, for example, the IRS expert concluded that since the two executives performed menial tasks, there was a rationale for reduced salaries. Also, because they worked far more than 40 hours a week, they weren’t as effective as higher-paid executives who put in normal work weeks and who delegate tasks. And because no other companies actually sought their services for executive-level positions, the IRS deemed their compensation excessive. The expert failed to consider that executive/owners (shareholder/employees) do not readily abandon their businesses as opportunities arise and, therefore, are not often the targets of an executive search.

In other words, the IRS found that if the two executives were really good, they wouldn’t have to work so hard. For one thing, this is inconsistent with case law.

For obvious reasons, the expert also ignored prior Tax Court decisions in favor of shareholder/employees. In a similar case from the 9th Circuit, Elliotts Inc. v. C.I.R., the court found in favor of the shareholder/employee. It ruled that because the executive in question handled multiple job functions and worked excessive hours, he should be compensated for his entire workload.

ALWAYS BE PREPARED

The key to executive/owner compensation is “the independent investors test,” which compares remuneration with the returns sought by most independent investors. Typically, a 6 percent dividend rate based on a company’s opening equity account as part of a 20 percent growth in shareholders’ equity would be considered exceptional. The salaries of the California executives exceeded these standards and were equivalent to a compound return on their original investment well in excess of 60 percent. (This figure is based on the capitalized values associated with this particular industry.)

An analysis of this company by EMCO/Hanover determined that it likely would have been purchased by a competitor–provided its executive/owners agreed to the transaction. Of particular interest in this case, as mentioned earlier, is the exceptional management by these executives of their own gross margins.

Often in court, the IRS will try to skirt a precedent case such as Elliotts. It will try to demean the performance and unique credentials of the person(s) in question. This becomes the cornerstone of any rebuttal process.

Without question, fighting any case of this nature is an uphill battle. Generally, the IRS aims to extend the proceedings to exhaust your patience, your financial resources, or both. This way you will be more prone to settle at some disproportionate amount.

Remember, compensation is discretionary and dependent upon a company’s circumstances and activity. While executive pay is a sensitive subject with most laymen, in some cases, higher than average compensation is justified. In any case, if the IRS knocks at your door, knife and fork in hand, be prepared. Written justification compiled in the course of doing business may help to ensure that you aren’t part of the entree.

Bruce W. Barren is chairman of The EMCO/Hanover Group, an international merchant banking firm that has completed more than $3 billion in financial transactions since 1971. He specializes in matters related to senior management, including mergers and acquisitions, board representation, online management, corporate planning, financial administration, and capital sourcing.