Zeroing Out of Profits by Closely Held Corporations
Shareholders of C corporations sometimes pay themselves bonuses in an amount that eliminates corporate profits, thereby eliminating the corporate tax that would result if paid on dividends (resulting in a “double tax”). However, several recent cases shed light on how paying supplemental shareholder compensation may backfire if not properly implemented.
Under the “zero out” technique, a C corporation compensates its shareholders by paying a portion of its anticipated pre-tax operating profits as salary in regular increments during the tax year and then distributes the bulk in bonuses at the year end. This reduces or possibly entirely eliminates federal income taxes on the compensation at the corporate level. This also requires that the shareholders genuinely provide services to the corporation, but that is not where the inquiry ends. Depending on the facts and circumstances of a particular sale, the IRS may disallow the deduction for salary and instead treat the payments as nondeductible dividends made by the entity to its shareholders.
Specifically, the IRS may disallow the compensation for either of these reasons: payments were excessive based on the services provided, or the payments were not purely for services. However, despite recent cases, it still may be possible to properly structure compensation that is deductible for services rendered by avoiding the pitfalls encountered in Clary Hood, Inc., and the Aspro case.
In Aspro, Inc., 129 AFTR2d 2022-1581 (CA-8, 4/26/2022), aff’g Aspro, Inc., the Eighth Circuit Court of Appeals affirmed a Tax Court decision which held that the IRS’s characterization of payments from the taxpayer, a C corporation were non-deductible dividends. The C corporation had reported them as deductible compensation payments for management services. The C corporation operated an asphalt paving business, which generated income throughout the year from various bids made on paving contracts. Management fees were paid at year end only. No payments were made for services to or for the benefit of the shareholders. In a 2021 decision, the Tax Court found that the payments could not be deducted as compensation for services rendered, where the payments were made only at the year’s end and were made roughly based on share ownership rather than on the value of services provided by each individual. The salary payments had eliminated a substantial portion of otherwise taxable income, with just under 90% in two of the three tax years examined and just under 80% in the third year.
Under Treas. Reg. 1.162-7(a), a reasonable allowance for salaries may be included as ordinary and necessary expenses in carrying on a trade or business. The test of deductibility in the case of compensation is whether it is reasonable and are in fact payments purely for services. Under subsection (b) of the same regulation, this test is further clarified as to prohibit the application to excessive salaries, which are those in excess of those ordinarily paid for similar services or those that bear a close resemblance to the stock holdings.
The Court in Aspro noted that while all compensation payments within closely held corporations should be closely scrutinized, payments made in a lump sum at the end of the year resulting in nearly zeroing out all taxable income (and resulting in no income tax due), without any dividend payments ever made by the Corporation will simply not pass muster.
In Clary Hood, Inc. (TC Memo. 2022-15), decided on March 2, 2022, the Tax Court redetermined the deductible amount of the substantial one-time bonuses that a closely hold construction company paid its CEO during two tax years. The Tax Court found that not all of the bonus amount paid to the sole shareholder could be deducted as reasonable compensation for the services provided. The Court did find that a significant portion could be deducted. The Court noted in support of the significant portion, that the bonused amount was 40% of profits in one year and 25% of profits in another year.
These cases reinforce the need for proper structuring of compensation methods from the C corporation to the shareholder. A one-time end of year bonus payment should be avoided as well as the amount being proportional to shareholder interest. Compensation should also not be excessive and must take into account the value of the services provided by each individual. To provide that value, written employment agreements should be maintained with each shareholder continuing to receive a salary and provide services, which contains an objective formula and with an obligation for each shareholder to submit period reports of the work performed in support thereof.