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WHAT'S MOM WORTH?

August 19, 2003

It's safe to say that few children dream of attaining a Tax Court judgeship. The rare child who is aware that such a creature exists is also advanced enough to know what Judge Learned Hand had to say about the subject of the Tax Court's work:

"The words of such an act as the Internal Revenue Code merely dance before my eyes in a meaningless procession, and leave in my mind only a confused sense of some vitally important, but successfully concealed, meaning which is in my ability to comprehend only after an inordinate expenditure of time.

But it gets even worse. In a recent case, the Tax Court had to tell a family that their mother wasn't nearly as valuable as they had thought.

IS $800,000 PER YEAR RIGHT FOR MOM?

E.J. Harrison and Myra Harrison started a trash hauling business in California in the dark depression year of 1932. It did well enough to provide a jobs for their three sons when Mr. Harrison died in 1991, by which time the business had been incorporated as E.J. Harrison and Sons, Inc. Myra was kept on by her grateful sons. The sons thought quite a bit of their mother, paying her $808,041 in 1995, $764,664 in 1996 (the year she turned 80), and $541,325 in 1997.

Myra worked at the office three days a week. The Tax Court says her work

"...consisted in part of filing and maintaining historic company records. She also looked over proposed trash hauling contracts before signature, and she reviewed bills and signed checks prepared by others in payment of those bills. She was the only officer with authority to sign checks without a countersignature. On occasion, she attended meetings arranged by one or more of her sons with drivers or other employees where her fluency in Spanish was of use. In addition, she met with bankers in connection with her loan guaranties."

She also had a public relations role, representing the corporation at civic events. While many of her contemporaries were on the golf course or at the bridge table, her civic and office work typically took 40 hours or more a week.

SO WHAT'S THE PROBLEM?

Closely-held businesses have battled the IRS over "excessive compensation" since the early days of the tax law. Nowadays this battle is primarily fought by C corporations. The stakes arise because C corporations are taxed twice on their income - first when it is earned, and again when it is recovered by the shareholders through dividends or a sale of the stock. S corporations, in contrast, are only taxed once; shareholders pay tax on the income as it is earned, and may then withdraw the earnings from the company without further tax.

If a C corporation can pays its earnings as deductible wages, it avoids the second tax. The corporation takes a deduction for the payment, eliminating the corporate tax; the executive/shareholder then pays tax on the wages. The IRS has often argued that such payments exceed the "reasonable" value of the employee/shareholder's services, and are therefore really non-deductible dividends. When the IRS wins this argument, the C corporation double tax is preserved.

SO WHAT'S REASONABLE?

The IRS and the company took the argument over Myra's compensation to Tax Court. The battle became a contest of expert witnesses. The IRS expert won. The Tax Court concluded that Myra's duties "...were substantially similar to those of an outside board chair who does not otherwise perform the tasks of a chief executive or chief operating officer..." and that her pay was "... grossly in excess of what companies of a comparable size pay for such services." The Court used board chairs of comparable companies as a yardstick to determine that deductible compensation was $98,000 in 1995, $101,000 in 1996, and 106,000 in 1997.

IS EXCESS COMPENSATION STILL AN ISSUE?

Many companies avoid the excess compensation issue via an S corporation election. The IRS continues to assert the issue against closely-held C corporations. The recent reduction in the tax rate on dividends has lowered the stakes in this battle, but it hasn't eliminated them altogether. The IRS will still normally get to tax corporations at up to 35% on any compensation deemed "excessive." The recipient of the "excess" compensation will then pay the 15% tax on dividends, instead of the 35% rate that applies to wages. This still leaves the IRS 15% ahead on "excess" amounts.

WHAT TO DO?

S corporation status is still a good bet for prosperous corporations looking to avoid double tax. If an S election is impossible or uneconomical, a C corporation can still take steps to preserve its compensation deduction. Basic safety measures include annual review of salary and bonuses according to a formal plan; monitoring the compensation of other similar businesses as a benchmark for compensation; and paying at some amount as dividends. It can be difficult for a prosperous corporation that has never paid dividends to defend an excess compensation case.

With the rate on dividends being lowered to 15%, many senior shareholders may be more willing to take dividends than before. In some cases - particularly during a stretch of low corporate income years - the combined corporate and individual taxes will be lower if dividends are paid instead of wages.

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