Salt Lake City, Utah - I have had several responses to my blogs on what is and is not "reasonable compensation" and what is the big deal about this tax controversy issue anyway. To better explain, lets look at the case of Sean McAlary LTD, Inc., v. Commissioner. The issue before the court was whether or not Mr. McAlary paid himself reasonable compensation.
In 2006, McAlary's company had net income of $231,454, McAlary took a distribution of $216,000, and a salary of $24,000, which amount was based on a compensation agreement between McAlary and the corporation. The IRS during its audit, found that McAlary had reasonable compensation of $100,755,. The IRS found that McAlary's primary job function was that of a real estate broker, that McAlary spent on average 12 hour days, 6 days a week, and the IRS compared McAlary LTD's performance with its peers in the real estate industry.
The IRS's rational was that based on a replacement cost assessment for services performed by McAlary. It found that if McAlary were to pay someone to replace him, McAlary LTD would expect to pay $48.44/hour in exchange for the services McAlary performed. $48.44 x 2080 (number of hours worked per year) his income should be: $100,755.
What did the court find? The court found that McAlary had a compensation agreement with the corporation paying himself $24,000, based on the meeting minutes of the board of directors. The court looked at the various services that McAlary performed for the corporation. The IRS found that the value of McAlary's services was an hourly wage amount of $40 per hour, 2,080 x $40 equaling reasonable compensation of $83,200. In making this finding the court found that the IRS "did not explain how a comparison of compensation measured as a percentage of gross receipts with compensation measured as a percentage of net sales would aid the Court." In addition, the court found that the compensation agreement was not a sound agreement especially because the agreement was "clearly . . . not the product of an arm's length negotiation."
So, what does this mean to you? Be careful in how you calculate what is considered reasonable compensation. Work with professionals that understand reasonable compensation issues and compensation calculations.
Tax problems are legal problems and we solve both. We help taxpayers with tax resolution and tax controversy matters. If you or someone you know has a tax controversy with the IRS, you can reach Kent at: https://strongandhanni.com/attorneys/attorney-kent-brown/ or you can email or call him at: kbrown@strongandhanni.com or (801) 532-7080.
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