In 1972, a son took over his father’s foundering packaging business as CEO. Over the next thirty years, he bought new equipment, refurbished a new factory, and attracted new clients, building the firm’s annual revenues to nearly $10 million. In 2002 and 2003, his total annual compensation (salary plus performance bonus) exceeded $2 million—and the IRS challenged the amounts as deductions, allowing only $660,000 per year. At trial to the Tax Court, both parties’ experts analyzed the CEO’s compensation by reference to public company comparables, but only the IRS expert applied the “independent investor” test (i.e., whether an independent investor would be satisfied with the rate of return after investing in the taxpayer). The court found neither expert “completely convincing,” largely because their comparables were not sufficiently similar to the taxpayer.  So, the court did a thorough analysis of all the evidence under the “five-factor test” of Elliott’s Inc. v. Commissioner, the 9th Circuit decision (1983) that looks to comparable companies and also the employee’s role within the firm, its financial condition, conflicts of interest, and more. The court then allowed all of the taxpayer’s compensation in 2002 and substantially all ($1.28 million) in 2003.

“This is a great victory for small business entrepreneurs in terms of the logic in paying them fair value for their contributions to an enterprise’s success,” comments Ron Seigneur (Seigneur Gustafson LLP). “This case also has an excellent discussion of the Elliotts decision as well as the independent investor test,” he adds. “Most importantly, it points out why business owners need financial experts to help them sort out what constitutes reasonable compensation for tax and other analyses.” Read the complete digest of Multipak Corp.v. Commissioner, T.C. Memo. 2010-139 (June 22, 2010) in the Sept. BVUpdate; the court’s opinion will be posted soon at BVLaw™.

More importantly, watch for BVR’s Guide to Reasonable Compensation, by Ron Seigneur and Kevin Yeanoplos, coming soon to BVR’s full-reference online library and bookstore.