Extreme Care Should Be Exercised in Setting Salaries in Family-Run Businesses

Originally published by Axel Lindholm.

Signaling that reasonable compensation is always a factual issue, the Federal Tax Court recently ruled that compensation paid during a two-year period to four sons of the principal shareholder in a family-run business was not deductible under Internal Revenue Code § 162. The court found that corporate officers had disregarded objective and relevant facts and failed to utilize independent judgment in the setting of the sons’ compensation [see Transupport, Inc. v. Commissioner, T.C. Memo. 2016–216]. The decision reminds the principals in all closely held businesses that great care should be exercised in the setting of salaries, particularly for employees who are related to dominant shareholders.

Typical Family-Run Business

The facts in the Transupport case were pretty typical. In the year prior to making the sons employees of the company, the president and 98-percent owner of Transupport transferred shares in equal percentages to his four sons via gifts and sales. Thereafter, the corporation’s president and his four sons were the only employees and officers during the tax years in question. The president set his sons’ salaries without consulting the company’s CPA (or anyone else, for that matter). The court indicated the four sons had little or no knowledge of the job functions for which they were compensated. The court added that an expert hired to assist the corporation in the tax court litigation looked at comparable compensation at manufacturing facilities, while the family-run business was a wholesaler. The expert’s opinion was of little value, indicated the court.

The court left unchallenged the compensation paid to the majority shareholder/president since he had extensive experience in the business, and based upon the fact that his own compensation was in the median range of the comparable firms. The court imposed penalties of 20 percent of the understatement of earnings due to the improper compensation.

Tips to Avoid the Unreasonable Compensation Problem

The Transupport decision is a textbook example of where successful, closely held businesses often go wrong. Corporate records were scanty. Virtually no contemporaneous documentation of comparable salary information was assembled at the time when the salaries were set. The court indicated that the employee relationship was merely a means of transferring wealth from one generation to the next.

Family-run businesses should be careful that they do at least the following:

• Make sure they have adequate support for all deductions, not just salaries and other compensation.
• Recognize that in order to be deductible under § 162, compensation paid must be reasonable. Payments to family members are generally subject to special scrutiny.
• Corporate files should contain relevant and real documentation, such as resumes of employees who are family members, compensation studies and data from comparable businesses, and any published comparables.
• HR files should contain real performance evaluations regarding employees, particularly those who are related to dominant shareholders.

Romano & Sumner – Skilled, Experienced Legal Counsel

The attorneys at Romano & Sumner have more than 20 years of combined experience providing expert legal assistance to clients in all types of complex wealth management, tax planning, and asset preservation issues. We represent family-run businesses and have intricate knowledge of issues such as those presented in the Transupport tax dispute. At Romano & Sumner, we pride ourselves not only upon our professionalism, but also upon our client service. We know that each situation is unique. We return phone calls within one business day. We keep clients informed. We complete the work within the allotted time frame. Call us at 281-242-0995 or complete our online contact form.

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