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Determining Reasonable Compensation Related to Earlier Undercompensation

In Devine Brothers, Inc. v. Commissioner (Tax Court Memo. 2003-15), the Tax Court held that the compensation paid to a corporation’s founder was, in light of undercompensation in earlier years, reasonable compensation.

Devine Brothers (DB) is a family-run mechanical contractor business that performs heating, air conditioning, and plumbing services. In the late 1970s, DB experienced financial and business problems due to delayed projects and a general contractor’s bankruptcy.

In the 1980s, DB began to increase its retained earnings in order to expand its bonding capacity to better compete in the direct bid market. DB needed to keep 10 percent of its revenue in liquid assets to meet the bonding requirements. To accomplish this, DB underpaid its president in order to keep liquid assets in the company.

In 1995, DB increased the president’s salary from $51,633 (in 1994) to $260,378. When DB claimed a deduction for compensation of the president on Form 1120, the IRS disallowed $65,000 of the $260,378 under the contention that it was excessive.

However, the IRS did concede that the president’s salary fell "...in the range of salaries paid to presidents/chief executive officers of comparable companies in the same industry during the taxable year."

The court determined that the petitioner made a prima facie case for reasonableness and that the IRS provided no evidence to the contrary. The IRS gave no reasoning for its calculation of the "excessive" compensation. The court noted that the founder was previously undercompensated and concluded that the bonus compensated him for the earlier undercompensation. Therefore, the court held that the entire compensation deduction was reasonable.

 

This text is provided with the understanding that ECFA is not rendering legal, accounting, or other professional advice or service. Professional advice on specific issues should be sought from an accountant, lawyer, or other professional.

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