Robert C. Ricketts, CPA, PhD
1806 FM 1294, Lubbock, Texas 79403
(806) 746-5351
DATE: August 20, 2007
TO: Internal Revenue Service
FROM: Robert Ricketts, CPA
RE: 2004 and 2005 Assessments – Dr. Jennifer Baker
I have been asked by Dr. Jennifer Baker to review IRS assessments of deficiencies on her 2004 and 2005 individual income tax returns, as well as the assessment of deficiencies in the payroll tax liabilities of her wholly-owned S corporation for those same years. Having completed my review, it is my professional opinion that those assessments overstate Dr. Baker’s and the S corporation’s true obligations for underpaid taxes for both years.
The primary issue in this dispute has to do with the salary drawn by Dr. Baker from her wholly-owned S Corporation. Although the S Corporation reported net income of almost $300,000 over the two year period, Dr. Baker drew salaries of only $24,000. These salary payments were unreasonably low. However, the Revenue Agent’s report errs in the opposite direction, overstating the salary that Dr. Baker “reasonably” should have drawn. Specifically, the agent’s determination improperly ignores the level of personal services that Dr. Baker actually provided to the S corporation during the years in question. Ignoring the services actually rendered by Dr. Baker contradicts the plain language of Section 162 of the Internal Revenue Code and the related Treasury Regulations.
Determination of a “Reasonable Salary” for Dr. Baker for 2004 and 2005
Code Section 162
Dr. Baker is the sole shareholder of Jennifer Baker O.D., P.A., a professional association taxable as an S corporation for federal income tax purposes. In 2004, the corporation paid Dr. Baker a salary of $11,500. In 2005, it paid her a salary of $12,500. The remainder of the S corporation’s taxable income, which was $202,016 in 2004 and $114,866 in 2005 (not adjusted for IRS assessments), was reported on Schedule E on Dr. Baker’s individual income tax return. The IRS examiner asserts that the amounts paid as salary to Dr. Baker in 2004 and 2005 were not reasonable. She proposes that a reasonable salary would be $105,000 for both years.
I agree with the examiner’s determination that the salaries paid to Dr. Baker were not reasonable. However, I do not agree that $105,000 is a reasonable estimate of the salaries she should have been paid. For reasons explained below, I believe that a reasonable estimate of the salaries that should have been paid to Dr. Baker would be between $33,000 and $60,000 for 2004 and 2005.
There is a long line of case law addressing the question of what constitutes a reasonable salary to be paid by a corporation to its shareholder(s). All of this case law is grounded in an analysis and application of the requirements of IRC §162(a)(1) and the Treasury Regulations thereunder.
Section 162(a)(1) permits a corporation to deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered" (emphasis added). Treasury Regulations §1.162-7(a) amplify this statute as follows:
“There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services” (emphasis added).
The Regulations go further, at §1.162-7(b)(3), stating 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.”
As indicated by the phrases highlighted above, the law and the regulations are clear that the determination of what constitutes a reasonable salary is dependent on the services actually rendered by the shareholder to the corporation, and that in order for payments to the shareholder to be reasonably characterized as salary, they must be based purely on the services rendered by the shareholder to the corporation. Further, a reasonable salary for such services actually rendered by the shareholder is what the shareholder would be paid by an unrelated entity for the services rendered or, stated differently, what the corporation would pay to a non-shareholder for like services.
In the case at hand, the IRS observed Dr. Baker at work over an extended period of time. My understanding is that the IRS concluded that Dr. Baker worked approximately 18 hours per week during the years in question, for a total of approximately 1,000 hours per year. The question is therefore what would be a reasonable salary for a half time professional.
There are a number of objective measures available to estimate a reasonable salary for a shareholder who works half the year. In Dr. Baker’s office, she employed two full-time ODs. One, Dr. John Smith, was paid $28,500 for a half year’s work (full-time for one-half year). The other, Dr. Mark Edmonds, was paid an annual salary of $66,000 for full-time employment providing exactly the same service to the S corporation as Dr. Baker. One of these doctors (Dr. Edmonds) was new to the profession, while the other had been practicing for over 30 years. Based on the services provided by these doctors, and the hours they worked, it would be reasonable to assume that the S corporation would be willing to pay, at most, $33,000 to a non-shareholder providing professional OD services on a half-time basis.
An alternative indicator of the value of the services actually rendered by Dr. Baker to the S corporation is provided by the Department of Labor. In a report referenced by the IRS examiner, the Department of Labor estimated that a reasonable salary for a doctor of optometry in the Lubbock area for the period in question was $60 per hour. Applying this estimate to the hours Dr. Baker worked would yield an estimate of the salary she should have been paid of $60,000.
The IRS examiner also referenced a number of web sites providing estimates of the salary that an optometrist could expect to earn in the Lubbock area. The average wage from these web sites (including the Department of Labor estimate) for full-time employment was $105,000 per year. This is the figure the examiner asserted to be a reasonable salary for Dr. Baker. However, given that the tax law specifically requires that a reasonable salary must be tied to the services actually rendered by the taxpayer shareholder, this figure should be reduced to reflect Dr. Baker’s actual work schedule. As a half-time employee, these figures would suggest that a reasonable salary would have been $52,500.
Overall, these figures suggest that a reasonable salary for Dr. Baker would have been somewhere between $33,000 and $60,000 for the years in question. The estimate of $105,000 significantly overstates what the S corporation would have been willing to pay to a non-shareholder for the services actually rendered by Dr. Baker.
Case Law
Case law is generally consistent with the above analysis. Consistent with the plain language of the statute and the accompanying regulations, the courts look to the services actually rendered by a shareholder-employee in order to determine what constitutes reasonable compensation. For example, the 8th Circuit Court of Appeals has ruled that where a closely held corporation bases its officers’ pay on the corporation’s earnings, rather than on the services rendered by those officers, the compensation is more likely to constitute a distribution of earnings rather than salary (Builders Steel Co., CA-8, 52-1 USTC ¶9360, 197 F2d 263). See also Standard Asbestos Mfg. and Insulating Co., CA-8, 60-1 USTC ¶9370, 276 F2d 289 in which the 8th Circuit determined that bonuses based on earnings rather than on services provided by key shareholders in either the current or past years did not constitute reasonable compensation. Indeed, in a long line of cases, spanning the period from 1955 through 2001, the Tax Court has held that to be treated as salary payments, compensation paid to shareholders “must be paid for services actually rendered as well as be reasonable in amount” [e.g., Hatfield Packing Co., TC, Dec. 21,250(M), 14 TCM 1048, TC Memo, 1955-264, Eberl's Claim Service, Inc., TC, Dec. 53,434(M), 77 TCM 2336, TC Memo 1999-211, Normandie Metal Fabricators, Inc., TC, Dec. 53,815(M), TC Memo 2000-102, 79 TCM 1738, and Wagner Construction, Inc., TC, Dec. 54,390(M), TC Memo 2001-160, 81 TCM 1869]. It is noteworthy that the Tax Court issued each of the above cited opinions as Memorandum Decisions, indicating that they deal with a settled issue in the tax law.
The IRS examiner’s report cites a number of authorities in supporting its contention that Dr. Baker should have been paid a salary of $105,000. However, many of these citations merely address the issue of whether she should have been paid a reasonable salary (e.g., Radtke 89-2 USTC ¶9466, Revenue Ruling 71-86, 1971-1 CB 285, Revenue Ruling 74-44, 1974-1 CB 287, and Greenlee 87-1 USTC ¶9306). These authorities emphasize that Dr. Baker be paid reasonable compensation for services rendered but they do not help in determining what that salary should be. In Spicer Accounting, Inc., 91 USTC ¶50,103, and Revenue Ruling 73-361, 1973-2 CB 331, also cited in the examiner’s report, the shareholders performed “substantial services for the firm.” In the current case, Dr. Baker worked as a part-time optometrist.
In determining reasonable compensation for services rendered by a shareholder, it is important that the Service take into account the actual services rendered by that shareholder. In focusing on the services actually rendered by shareholders, the courts have generally required that reasonable compensation be reduced where, as in this case, a shareholder did not devote substantial time to his or her duties to the corporation [e.g., see A. Arnold & Son Transfer & Storage Co., DC Ky., 59-2 USTC ¶9795, 178 FSupp 209], or where an increase in salary was not accompanied by a commensurate increase in services rendered [e.g., see L.M. Lefkowitz, 46 TCM 485, Dec. 40,215(M), TC Memo. 1983-356.
Perhaps the most significant court decision relevant to the current dispute is that handed down by the 5th Circuit Court of Appeals in Owensby & Kritikos, Inc, (CA-5), , 819 F2d 1315 (6/26/87), Aff’g TC. This case, which has been cited in at least 61 subsequent court decisions, involved the determination of reasonable salaries for three key shareholders in a closely held corporation for which capital was not a material income-producing factor (as is the case in the current dispute).
In this case, the 5th Circuit ruled that “any amount paid in the form of compensation, but not in fact as the purchase price of services,” is not a reasonable salary. The court further noted that in determining the appropriate compensation for services provided by a shareholder, it is important to consider the level of salaries “ordinarily paid for similar services.” The court emphasized that “limits to reasonable compensation exist even for the most valuable employees” (emphasis added). Among the factors identified by the court as indicative of reasonable compensation, it particularly emphasized the level of compensation paid to non-shareholder employees (here $28,500 and $66,000 respectively) and compensation practices of comparable companies (here $55 to $60 per hour per the sources cited in the examiner’s report). It further considered the level of compensation as a percentage of the net income of the company, rejecting the taxpayers’ contention that 60% of net income constitutes a benchmark for reasonable compensation, and suggesting that compensation at this level of net income was excessive. It is worth noting that for tax year 2005, 60% of the income of Jennifer Baker OD, P.A. would be $76,420, a figure substantially below that suggested by the IRS as appropriate compensation for Dr. Baker. Given that she works only half-time for the corporation, this level of salary would not be reasonable as it exceeds what would be paid for personal services actually rendered by Dr. Baker.
Finally, the court considered the issue of what shareholders would expect as a return on their investment in a company. It is important in the current dispute to consider how Dr. Baker’s S corporation has built its earnings. As indicated in the accompanying table, Dr. Baker began this practice in 1994. From 1994 until 1997, the gross revenues of the practice averaged just under $340,000 per year. In 1997, Dr. Baker purchased an additional practice from another optometrist. She did not retain the employees of that practice. From 1998 through 2004, the combined gross revenues of the two practices (the original practice and the newly acquired one) averaged approximately $665,000. In 2005, she purchased a third practice, again without retaining its employees. The corporation’s annualized gross revenues after folding the third practice into her existing company grew to just over $1 million. Thus, by 2005, two-thirds of the gross revenues of the S corporation were attributable not to optometry services provided by Dr. Baker, but to her decision as an investor to purchase additional patients from other optometrists. These patients could be efficiently handled by her existing staff, plus the services obtained by hiring additional full-time doctors of optometry.
A reasonable inference is that income of the S corporation attributable to Dr. Baker’s decision to invest in additional practices is not properly subject to employment taxes, especially given that she does not appear to have increased the level of services that she personally provides to the corporation as an employee. Indeed, Dr. Baker’s contention is that the key to profitability in her line of work is to ensure that her practice is included on the approved lists of optometrists by as many area insurance providers as possible. This is a plausible view. Although Dr. Baker has an outstanding reputation as an optometrist, this reputation is not what brings patients to her practice. In fact, many of these patients are treated by optometrists other than Dr. Baker. The primary draw to these patients is that Dr. Baker’s practice is listed by their insurers as an approved provider, a requirement for their insurer to cover the cost of services provided by her practice.