Legal Bulletins

For the second time in 2016, the United States Tax Court (the “Court”) has issued a decision involving the application of the independent investor test in considering the issue of reasonable compensation for a C corporation. On May 11, 2016, the Court released its decision in H. W. Johnson, Inc. v. Commissioner, TC Memo 2016-95 (“Johnson”), a case in which the Court determined that the taxpayer satisfied the independent investor test and, therefore, found that the amount of compensation paid was reasonable.

Earlier this year, on February 10, 2016, the Court issued its decision in Brinks Gilson & Lione v. Commissioner, TC Memo 2016-20 (“Brinks”), a case in which the Court determined the independent investor test was not satisfied, and agreed with the Internal Revenue Service’s (the “Service”) disallowance of a deduction for compensation.

It may be prudent for C corporation taxpayers that pay compensation to their shareholders to note how the taxpayer in Johnson was able to successfully defend a deduction for the compensation it paid to its shareholder-employees.

In Johnson, the taxpayer operated a concrete contracting business. The taxpayer utilized a formula to determine the amount of bonuses paid to its shareholder-employees and it also had a dividend plan that called for dividend payments when its retained earnings exceeded $2,000,000. During each of the tax years at issue, 2003 and 2004, the taxpayer paid its two shareholder-employees aggregate compensation of $4,025,039 and $7,300,916, respectively, which consisted of aggregate bonuses of $3,500,000 and $6,800,000, respectively. During those same two tax years, the taxpayer paid dividends in the amount of $50,000 and $100,000. The Service argued that $811,039 and $768,916, for each year, respectively, should be disallowed as exceeding reasonable compensation.

The Court noted that the Court of Appeals for the Ninth Circuit, to which an appeal of Johnson would lie, utilizes the following five factors to determine the reasonableness of compensation, with no one factor being determinative of the issue: (i) the employee’s role in the company; (ii) a comparison of compensation paid by similar companies for similar services; (iii) the character and condition of the company; (iv) the independent investor test; and (v) the internal consistency of compensation. The Service effectively conceded that four of the five aforementioned factors either supported, or were neutral regarding, the reasonableness of the compensation paid by the taxpayer, but argued that the fourth factor, the independent investor test, supported a ruling against the taxpayer. After briefly considering the other four factors, the Johnson court focused squarely on the independent investor test.

The independent investor test assesses the reasonableness of compensation from the perspective of a hypothetical independent investor by focusing on such investor’s return on equity. Thus, if the payment of compensation would reduce the company’s earnings on equity to a level that would not satisfy an independent investor, then there is a strong indication that such payments should not be deductible as compensation and should be recharacterized as dividends.

In Johnson, it was undisputed that the taxpayer’s pre-tax return on equity for the years at issue was 10.2% and 9%, respectively (calculated as pre-tax net income of $387,706 divided by equity of $3,786,218 for 2003; and pre-tax net income of $348,579 divided by equity of $3,888,584 for 2004). The Service and the taxpayer, however, disagreed on what an appropriate return on equity should be for the taxpayer.

The Service’s expert stated that an appropriate return on equity for the taxpayer should range from 13.8% to 18.3%. The Court, however, was skeptical of such a range because the expert derived its numbers from companies that were not comparable (in terms of industry and sales volume) to the taxpayer, and used data that admittedly may not have been fully representative of the taxpayer’s industry. The taxpayer’s expert, using data from companies that the Court found to be more comparable to the taxpayer than those used by the Service’s expert, determined that an appropriate return on equity for the taxpayer during the years at issue was 10.5% and 10.9%, respectively, meaning that the taxpayer’s actual returns on equity for the contested years fell short of its expert’s percentages by only 0.3% in 2003 and 1.9% in 2004.

The Service then argued that because the taxpayer’s returns on equity fell below the industry averages, an independent investor would have required a higher return. The taxpayer, on the other hand, asserted that its returns generally were in line with industry averages and, therefore, its actual returns would have satisfied the hypothetical independent investor.

The Court, having no concern that the taxpayer’s actual returns were slightly below the industry averages as suggested by the taxpayer’s expert, found that the taxpayer satisfied the independent investor test. In making its ruling, the Court cited other cases that found a return on equity of at least 10% tends to indicate that an independent investor would be satisfied, thereby not requiring the recharacterization of compensation to dividends. The Court noted that it has previously ruled that a return on equity as low as 2.9% has been found to be reasonable, while pointing out that it is when a return on equity falls to zero that the independent investor test will not be satisfied.

The Court’s decisions in Johnson and Brinks provide valuable guidance for C corporations that pay compensation to their shareholder-employees with respect to how to satisfy the independent investor test in the context of reasonable compensation. First, C corporations with significant equity that completely eliminate book income by paying bonuses to their shareholder-employees, thereby causing pre-tax returns on equity of zero, will most likely fail the independent investor test. Second, the failure to pay more than a modest dividend will not necessarily harm a taxpayer’s assertion that it satisfied the independent investor test. The Johnson court was not troubled by the modest dividends paid for the years at issue, implicitly recognizing that a shareholder may participate in the success of a corporation, not only through dividends, but also through the appreciation in the value of his stock fueled by retained earnings, and that some investors prefer stock appreciation over dividends.

For more information, please contact Douglas T. Coats at 410-576-4002