Don’t Be Unreasonable

Much has been written of late regarding the payment by a business of various personal expenses incurred by its owner or certain key employees.

The payment of an owner’s personal expenses appears to violate a basic precept of the tax law with respect to the use of business assets[i] – specifically, that their use be limited to furthering the purposes and interests of the business.

This precept emanates from what is perhaps the golden rule for dealings between a closely held business and any of its owners and “related” persons: that they transact with one another on terms that are as close to arm’s length as practicable.

Various iterations of this “rule” are expressed throughout the Code.

For example, for purposes of determining its income tax liability, a business may claim a deduction only for the ordinary and necessary expenses paid or incurred in carrying on the business.[ii] This includes a reasonable allowance for compensation to an employee (including an owner-employee) for services actually rendered to the business, regardless of the form of the compensation;[iii] in other words, the compensation may be paid, in part, by satisfying an employee’s personal obligation to a third party, or a compensatory benefit may be transferred to the employee via the rent-free use of employer property.[iv]

Provided the compensation is paid pursuant to a free bargain between the employer business and the employee, made before the services are rendered,[v] and not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the employee,[vi] it should be allowed as a deduction for purposes of determining the employer’s taxable income provided the employer reports the payment in a manner consistent with its purported compensatory nature, and provided the value of what is paid is reasonable.

If the amount paid to an owner or to a key employee ostensibly as compensation exceeds what is reasonable for the services rendered by the owner or employee – the taxpayer has the burden of proving the amount was reasonable – the IRS will scrutinize the payment and the surrounding circumstances to determine its true nature.

In the case of the owner, for example, any amount paid in excess of reasonable compensation may represent a distribution of earnings from the business; if the ultimate payee is someone other than the owner, the excess value transferred to the payee may constitute a gift from the owner, depending on the facts and circumstances.   1

It is implicit in the foregoing that an employer-business will deal at arm’s length with an unrelated person – it would never knowingly pay compensation in excess of the value of the service or property provided[vii] – whereas the business may be more generous toward one of its owners and those related to them.

Difficult Choices

Unfortunately, many – perhaps most (?) – closely held businesses ignore the golden rule to some degree. The owners choose to transact with the business – or the business chooses to transact with them – on other than arm’s length terms, which may include the diversion of business assets for an owner’s uncompensated personal use.[viii]

Although many owners seem to be oblivious to the questionable nature of such transactions, they are certainly made aware of them at that point in the life cycle of the business when the owners must confront the possible disposition of their business.

For example, the owner may consider the possibility of selling the business to an unrelated party. Depending upon the buyer, the owner may be looking to monetize their entire investment in the business, or they may decide to liquidate most of that investment while retaining (or rolling over) the remaining portion in the hope of participating in any increased profits and appreciation that the buyer may be able to generate.

Add-Backs

When valuing the owner’s business for purposes of setting a purchase price, a potential buyer will want to develop as accurate a picture of the business’s earnings and cash flow as possible.

The buyer will try to normalize those earnings by, for example, “adding back” various “business” expenses that the buyer is unlikely to incur in the ordinary course of operating the business after its acquisition.

The buyer will know that the owners of closely held businesses, and especially family businesses, often pay a greater-than-market rate of compensation to themselves or to family members and related entities in exchange for their services or for the use of property that is held outside the business.

Thus, the most common add-backs involve “excessive” payments made or expenditures incurred by the business to or for the benefit of the owner or persons who are “related” to the owner. This would include, for example, compensation paid to a child for a no-show job.

However, in the case of a family member who is employed by, and provides a valuable service to, the business – a service for which the buyer will have to pay after the acquisition – the add-back will be limited to the amount, if any, by which the payment made in exchange for such services exceeds reasonable compensation.

Having determined the appropriate add-backs and having otherwise completed its financial due diligence, the prospective buyer will offer to acquire the business for a fixed amount or, depending on the quality of the financials and the state of the relevant market, the buyer may offer a price that is partially contingent upon the future performance of the business (an earnout).

Status Quo?

At that point, the owners will have to consider several factors before they can agree to sell their business at the offered price.

The receipt of a sizable sum of money upfront in exchange for the assets of the business would eliminate the concentrated risk associated with the continued ownership of the business but will it be enough to meet the owners’ economic needs going forward?

To answer this question, the owners will have to determine the after-tax economic consequences of the sale – how much of the purchase price will they retain, how are they likely to invest it, and how much of an after-tax return can they reasonably expect to generate from such investment?

The owners will also have to identify and quantify the expenses to be satisfied from the after-tax sale proceeds (and the investment return thereon).

These expenses may include certain costs that historically have been paid for through the business but will be borne directly by the owners after the sale of the business; for example, the costs of health and life insurance, an automobile, certain travel, a cell phone, a club, and other items.

After the sale, the former owner would personally bear the cost of these items using after-tax dollars.

Also included among these expenses may be many of the add-back items identified by the buyer, such as the compensation paid to help support a child, to enable a family member to participate in retirement and health insurance plans, etc.[ix]

Following the sale of the business, many, if not most, of these family members will be looking for jobs, unless it would behoove the buyer to retain their services because they are key players in the continued success of the business. Query whether the former owner would feel some responsibility to help support these folks.

Based on the foregoing analysis, the owner may determine that they can’t afford to sell the business and should, instead, continue the status quo for as long as they can, or at least until they can transition the management, and eventually the ownership, of the business to younger family members and perhaps a key employee.

Take-Away

Assuming the owner decides to hold on to the business for the reasons mentioned above – which means they will continue the arrangements and the related payments that the prospective buyer identified as unreasonable or unnecessary – they will have to be prepared for the IRS to recharacterize these arrangements in accordance with their true nature.

Specifically, the deduction for certain wages will be disallowed, and certain compensatory payments will be treated instead as distributions in respect of the owner’s equity. Still other payments may be treated as gifts from the owner to the recipient of the economic benefit in question.

Alternatively, rather than waiting for the IRS to step in and dictate the appropriate tax treatment of the transactions between the business and its owners or related persons, the owner may want to reconfigure these economic arrangements to bring them into compliance with the golden rule. At least in this way, the tax consequences will be predictable. Moreover, any future buyer will encounter a business that is managed professionally (and less like a “mom and pop”) and the records of which accurately reflect its revenues and profitability.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] It may also give creditors a reason for pursuing the assets of the business to satisfy claims against the owner; that is, provided the payment is not intended as compensation paid in exchange for services.

[ii] IRC Sec. 162(a).

[iii] It is implicit that an employer will deal at arm’s length with an unrelated person – it would never knowingly pay compensation in excess of the value of the service provided.

[iv] Reg. Sec. 1.162-7. An amount of compensation is reasonable if it would ordinarily be paid for like services by a like enterprise under like circumstances. Reg. Sec. 1.162-7(b)(3).

[v] A comparable rule applies in the context of the excess benefit rules under IRC Sec, 4958. It must be clear that the payment represents compensation; one cannot, with the benefit of hindsight, recharacterize the payment on a retroactive basis.

[vi] The employer’s intention would be supported if the employer withheld and remitted the required taxes from the compensation.

[vii] Any apparent excess would almost certainly indicate that another transaction was involved.

[viii] For example, the NYC apartment owned by the business near Lincoln Center.

[ix] Then there are other factors to which it may be difficult to assign a monetary amount, including an owner’s ability to provide full- or part-time jobs to the spouses and children of family members.