Tax Blog

The Internal Revenue Code permits businesses to deduct their ordinary and necessary businesses expenses, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.” I.R.C. § 162(a)(1). The compensation must be “reasonable” and “purely for services.” Treas. Reg. § 1.162-7(a). For C-corporation shareholders, especially those in closely held businesses, the double-layer of taxation, effective income tax rates, preferential dividend rates, and other considerations create tension between whether to treat shareholder payments as nondeductible dividends or deductible compensation.  

As Judge Laro described that tension in Mad Auto Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153 at 5:

Inherently, there is a natural tension between: (1) Shareholders/employees who feel that they are entitled to be paid from a corporation's profits, even to the exhaustion thereof, of an amount that reflects their skills and efforts, and (2) a provision in the tax law that conditions the deductibility of compensation on the concept of reasonableness. What is reasonable to the entrepreneur/employee often may not be to the tax collector. Accordingly, this and other courts are repeatedly asked to examine relevant facts and circumstances of the business and the underlying employment relationship in order to render an opinion as to whether the compensation paid was reasonable. In so doing, we must be careful not to define the term "reasonable" too narrowly. The dynamic nature of business, the entrepreneurial spirit, and the dedication of purpose all play a role in the composition of reasonable compensation. We must not rigidly apply form over substance when we measure one's contribution to the success of his or her business. Of course, it may be argued that when an individual chooses to conduct his or her business in a corporate form, he or she is obligated to observe all the corporate formalities inherent in that form, including the standard to be deductible, the compensation paid must be reasonable. The term "reasonable," however, must reflect the intrinsic value of employees in the broadest and most comprehensive sense.

That tension leads C-corporations to draw distinctions between salary compensation and shareholder distributions.  In times where corporate tax rates exceed individual income tax rates, there may be incentive for shareholders to treat amounts as deductible compensation to lower corporate tax burdens and tax the amounts once at lower individual income tax rates.  In times where, as today, corporate tax rates are lower than high-end individual income tax rates, there may be incentive to treat amounts as dividends to take advantage of lower corporate and dividend rates (and avoid payroll tax obligations).

For the IRS, that tension and the resulting distinctions remains ground fodder to scrutinize compensation arrangements to determine whether the salaries are “reasonable”.  Historically, the IRS has drawn little distinction between payments set at, set at high levels to reduce corporate level taxation on those payments and those set artificially low to avoid higher individual income tax rates in favor of preferential dividend rates.  If, in the view of the IRS, the compensation structure does not qualify as “reasonable”, then the IRS will recharacterize those amounts.

For family-owned businesses, the IRS applies a “heightened scrutiny” standard to compensation arrangements involving the owners and their relatives, particularly their children.  Of particular concern is whether the “payments received were made on account of the employer-employee relationship or the family relationship.” Haeder v. Commissioner, T.C. Memo. 2001-7.

This higher scrutiny was on full display in the Tax Court’s recent decision in Hee v. Commissioner, T.C. Memo. 2026-53. Hee involved a C-corporation, Waimana Enterprises, Inc. (“Waimana”), owned by Mr. Albert S.N. Hee (“Mr. Hee”).  Waimana was incorporated in 1988. Mr. Hee was its sole shareholder and president during the tax years at issue. The corporation primarily acted as a holding company for its affiliates, but it also provided management services and supported each of its affiliates’ businesses.

During the tax years at issue, three of Mr. Hee’s children, (Adrianne, Breanne, and Charlton) received salaries and benefits from Waimana. Adrianne and Breanne started receiving salaries in 2006. Charlton began receiving a salary in 2008. Despite offering testimony from Waimana employees at trial that the children worked as employees, the Court was unpersuaded that they were reasonably compensated and disallowed the expenses associated with their salaries and benefits.

At the outset, the Court began by noting that the failure to adequately track hours worked or services performed could serve as a basis of finding that the compensation was unreasonable. In the Court’s opinion, Waimana had not kept adequate records of hours worked or services performed. In addition to the poor record keeping, the Court emphasized that all three children were full-time students during many of the years in question and simultaneously worked other jobs.  The Court held that the salaries and employee benefits paid to the children were not deductible. As a result of the disallowance, the salaries and benefits were treated as constructive dividends to Mr. Hee.

Mr. Hee’s wife, Mrs. Wendy Hee (“Mrs. Hee”), was also receiving a salary and benefits. She testified that she performed tasks such as reviewing and editing business documents, acting as a sounding board for her husband, and showed up to business functions.  However, aside from her testimony regarding these activities, little evidence was provided to justify the compensation paid to her.  The Court found that her salary and employee benefits were not deductible business expenses and instead constituted constructive dividends to the Hees.

Hee provides another reminder that at the heart of federal tax litigation (and most litigation) lies the documentation issue.  Most federal tax cases are won and lost years before they see trial based on the documentation and recordkeeping practices of taxpayers. 

Hee is also a clear example of the heightened scrutiny placed on compensation to family members where the presumption of arms’-length transactions gives way to self-dealing concerns, disguised gifts, and constructive dividends.  As a practical consideration, family-owned businesses should carefully document the decisions underlying their compensation arrangements, including the rationale supporting the amounts paid to members of the family. That includes documenting services provided, hours worked, competitive compensation of similarly situated employees (inside and outside of the organization), and consistent treatment with unrelated employees.  Of course, family-member employees should only be compensated for services actually performed. As the Tax Court made clear in Hee, a failure to maintain records of the time worked and services may be sufficient grounds for the IRS to disallow compensation deductions, even if family members do perform significant services for reasonable compensation.  With this concern in mind, family-owned business should consult with their tax advisers to ensure that appropriate documentation is maintained to withstand heightened IRS scrutiny.