The IRS frequently makes this adjustment in closely owned C corporations. In two cases, companies challenged the tax increase. The courts considered whether return on investment was adequate, after looking at the high officer/shareholder compensation as a non-employee shareholder would.

Brothers Dennis and Curtis Wagner owned the stock of Wagner Construction in International Falls, Minn. Its primary activity was sewer, water and road construction. It also did contract logging in the winter. The company employed about 40 people besides Dennis and Curtis. Dennis as president managed most operations and worked long hours six or seven days a week.

For the two years examined, the company paid the brothers $2.4 million. The agency said $1.5 million of this was a disguised dividend. So it reduced the corporation's deduction by this amount.

To support its position, the court explained:

• The company paid bonuses to officer/shareholders only.
  
• The company paid bonuses to Dennis and Curtis in proportion to their stock ownership rather than in relation to services.
  
• The company earned, over four years, $168,813 on an equity of $2,965,064. An independent investor would consider this inadequate.
  

Reducing the corporation's compensation deduction by $ 1.1 million, the court said this was in substance a dividend.

Leonard A. Damron III owned all the stock of a Florida company that recycled and sold used auto parts. He upgraded the 50-employee company from a basic salvage yard to a state-of-the-art showroom. He did the hiring, firing, buying, selling and all other management work. He worked so hard-about 95 hours a week-his wife divorced him.

For the three years examined, the corporation paid him $5.1 million. The IRS said this was excessive. It reduced the deduction by $3.6 million because it considered this a disguised dividend.

The court said the IRS position has some support because the corporation paid only one dividend over 16 years. But this does not control. Because of Damron's efforts, the corporation per year compound rate of return on investment was 39%. An investor would have been satisfied.

Damron won the case and remarried his wife.

Planning Tip. If you operate a closely held C corporation, look at the compensation paid officer/shareholders as an outside investor would. Many courts now rely most heavily on this yardstick. If you can't reduce their compensation, consider this: Convert the business to an S corporation or a limited liability company. But first, consult a tax specialist. You may not want to change if the tax cost of conversion is prohibitive or you plan to sell stock to the public. (more at Employer/Employee)

Released 1-21-02