Are you paying your children too much to work in the family business? The IRS might think so.

by Murtha Cullina

A United States Tax Court recently issued a decision after trial that should serve as a reminder to management and controlling shareholders of family-owned businesses that salaries or other compensation paid to family-member employees may only be deductible if the salaries are “reasonable.” In Transupport, Incorporated v. Commissioner of Internal Revenue, the Tax Court conducted a trial on the company, Transupport’s appeal of an IRS notice of deficiency.  In the notice, the IRS had determined that amounts the company attempted to deduct for compensation to four sons of the company’s founder and president were not reasonable.  The IRS also had disallowed the deductions to the extent of the unreasonable compensation and assessed a penalty based on a “substantial understatement of income tax.”

The company was a supplier of aircraft engines and engine parts. William Foote had founded the company in 1972. By 2006, Foote and his four sons were the company’s only full-time employees and officers.  Foote owned 98% of the company’s class A voting stock while his sons held 100% of the class B non-voting stock in equal amounts.  The Court noted: “[a]s in many family enterprises each of the Foote sons was involved early on in the business and did what was needed to be done to keep the family business successful.”  For the three year period at issue in the case, 2006, 2007 and 2008, the company paid each of the sons an identical yearly compensation of $575,000, $675,000, and $720,000.  Foote alone determined the compensation his sons received.  He paid them all equally in order “to avoid competition among them.”  Foote did not consult the company’s accountant or anyone else in setting his sons’ salaries.  Foote’s own compensation for that period ranged between $353,000 and $600,000, even though, as the Court found, the company’s success was due primarily to Foote’s efforts.

For each year, the company deducted the entire amount of the sons’ compensation. In 2009, the IRS began an audit of the company’s tax returns.  In that regard, the IRS prepared a reasonable compensation analysis.  Based on that analysis, the IRS did not adjust Foote’s compensation.  However, the IRS adjusted the sons’ compensation to a range between $250,000 and $265,000 for the three years at issue.  The notice of deficiency thus identified an aggregate adjustment of over $5,300,000 to the company’s allowable compensation deduction.

The Court noted that each of the sons “professed ignorance” as to the company’s operations and consistently testified to having “no clue” as to issues “basic to the performance of his respective functions” for the company.

The company appealed the notice of deficiency. After hearing testimony from Foote and his sons, the Court found that, as employees of the company, none of the sons performed any supervisory functions, and each performed various and overlapping tasks that might have been performed by lower level employees.  The Court also found that none of the sons had any specialized training, education or knowledge relative to their roles in the company.  In particular, the Court noted that each of the sons “professed ignorance” as to the company’s operations and consistently testified to having “no clue” as to issues “basic to the performance of his respective functions” for the company.  Further, the Court found that Foote, in materials prepared in connection with a possible sale of the company, had provided a third party with a financial summary which recast the sons’ annual salaries to a “market rate” of $50,000 each.

At trial, the company relied on a compensation expert in an effort to prove the reasonableness of the sons’ salaries. However, the Court found that, among other things, the expert did not consider the sons’ lack of specialized education or experience for their claimed officer-level positions with the company, Foote’s determination of the sons’ salary without consulting any third parties, Foote’s stated purpose to treat them all equally when setting salaries, the disproportionality of the sons’ salary to Foote’s own compensation, and the manner in which Foote set their salary in order to reduce the company’s reported taxable income to minimal amounts.

Further, the company’s expert only consulted one compensation data base – as opposed to various sources – in identifying the appropriate salary range for the sons. The expert also placed the sons’ salary in the 90th percentile of persons in allegedly comparable positions, even though the sons’ testimony showed they were not similarly situated.  Finally, the Court noted that the expert acknowledged that the purpose of his engagement with the company was “to validate and confirm that the amounts reported on the [company’s] returns were correct.”  In that regard, the expert “picked the biggest numbers” from the database to “reach a maximum compensation conclusion.”  After reviewing the expert’s methodology in light of the testimony and other available information, the Court found the expert’s analysis and opinion to be unreliable, as he “disregarded objective and relevant facts and did not reach independent judgments.”  The Court thus ruled that the company failed to satisfy its burden of proving that the sons’ compensation was reasonable or that the IRS’s notice of deficiency was erroneous.  Instead, the disallowance of the compensation deductions and the penalty for understatement of income tax remained in effect after appeal.

One of the hallmarks of a family-owned business is the employment of family members. However, as the Court in the Transupport case cautioned: “Compensation in closely held businesses is subject to close scrutiny because of the family relationships and is determined by objective criteria and comparisons with compensation in other businesses where compensation is determined by negotiation and arm’s-length dealing.”  Owners and management of family-owned businesses should therefore pay attention to such objective criteria when setting compensation for relatives working in the business.  Failure to do so could result in audits by taxing authorities, disallowance of deductions for compensation deemed to be not “reasonable,” underpayment penalties, and additional legal fees and costs of experts in connection with any appeals of the taxing authorities’ determinations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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