Reg. §1.162-7(b)(3) states that “it is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”
IRM §4.35.2.5.2.2 prescribes factors to be considered by audit personnel:
The examiner should take into account such factors as: nature of duties, background and experience, knowledge of the business, size of the business, individual's contribution to profit making, time devoted, economic conditions in general, and locally, character and amount of responsibility, time of year compensation is determined, whether alleged compensation compensate is in reality, in whole or in part, payment for a business or assets acquired, the amount paid by similar size businesses in the same area to equally qualified employees for similar services, etc.
In Rocco (57 TC 826), the court, in deciding issues related to the now revoked §1375, cited the now repealed Reg. 1.1375-3(a) which stated that when valuing the services rendered by a shareholder, all facts and circumstances of the business should be considered including the managerial responsibilities of the shareholder and the amount that would ordinarily be paid to receive comparable services from an uninterested party.
In a series of cases such as Mayson Mfg. Co. (38 AFTR 1028, (CA-6,1949)), Roob (50 TC 891) and Davis (64 TC 1048) the court considered several factors when reaching a reasonable compensation amount: the employee’s qualifications; the nature, extent and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with the gross and net income of the business; the prevailing rates of compensation with comparable positions in comparable concerns; the salary policy for all employees; and, the amount of compensation in previous years.
In Bramlette Building Corp. (25 AFTR 2d 709-1061 (CA-5, 1970), the Fifth Circuit cites Mertens Law of Federal Income Taxation §9.18 (1969):
In determining whether the amounts paid were compensation for services or were distributions of profits, all the facts and circumstances must be considered. Thus, the fact that the services were no more than anyone who was a large stockholder and a director in the enterprise would perform has been emphasized. It may further be significant that there is no corporate authorization for the payments as salaries. The courts will give consideration to book entries, whether amounts are withdrawn periodically or in a lump sum, and whether the payments bear a relationship to the earnings of the corporation, whether all the stockholder-employees receiving equal amounts rendered equal services, and to the relation between net income and the compensation paid.
Importantly, in Bramlette, the court introduced a relationship between dividends and corporate earnings by stating “the evidence shows that the payments were made not in proportion to the services the president rendered but rather in proportion to the profits of the corporation,” thus providing strong evidence of dividend treatment over salary.
The taxpayer in Radtke (63 AFTR 2d 89-1469, Affd by 65 AFTR 2d 90-1155 (CA-7, 1990)) was the only employee of his S corporation and paid himself no wages. In this case the court held “an employer should not be permitted to evade FICA and FUTA by characterizing all of an employee's remuneration as something other than wages.” A similar holding by the Ninth Circuit is found in Spicer Accounting Inc. (66 AFTR 2d 90-5806 (CA-9, 1990).
The Seventh Circuit has created a series of holdings on reasonable compensation (albeit directed more toward overcompensation than under-compensation). Starting with Exacto Spring Corp (84 AFTR 2d 99-6977 (CA-7, 1999), the court threw out the Tax Court’s (Heitz, TC Memo 1998-220) seven factor test used in the same case. The seven factors considered at the Tax Court level were: “(1) the type and extent of the services rendered; (2) the scarcity of qualified employees; (3) the qualifications and prior earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer's business.” Instead, the court examined the salary level in light of the rate of a return the corporation pays to its investors, otherwise known as the independent investor test. Decisions in the Seventh have continued to follow the independent investor test (e.g., Menard 103 AFTR 2d 2009-1280 (CA-7, 2009)).
Other circuits have continued to apply a variety of factors such as those listed in previous cases mentioned above. For example, the Ninth Circuit seems to follow Elliotts, Inc (52 AFTR 2d 83-5976 (CA-9, 1983)) which uses a five-factor test: (1) role in company, (2) external comparison, (3) character and condition of company, (4) conflict of interest, and (5) internal consistency.
Surprisingly, the Third Circuit does not appear to have considered this issue in any related way.