Reasonable compensation is a fact based analysis, and once again has been decided against the taxpayer. In Transupport, Inc. v Commissioner, T.C. Memo. 2016-216, the issue presented for decision was whether amounts deducted by the taxpayer, a distributor and supplier of aircraft engines and parts, during 2006‒2008 as compensation that was paid to the four sons of taxpayer’s president and majority shareholder were reasonable and deductible pursuant to Internal Revenue Code (IRC) Section 162 and whether accuracy related penalties applied. In 2005, the president and 98-percent owner of Transupport, gifted and sold shares in equal percentages to his four sons. The president and his four sons were the sole employees and officers for the tax years at issue. The president determined the compensation payable to his sons without consultation with his accountant or anyone else, and the only factors considered were reduction of reported taxable income, equal treatment of each son and share ownership.

In addressing the issue of taxpayer’s experts, the court concluded that they “disregarded objective and relevant facts and did not reach independent judgements,” and that the “experts’ opinions failed the sanity check” because the expert’s claimed the income and deductions on the Form 1120 were correct when the factual evidence showed that the returns were consistently inaccurate and the deductions excessive. The facts showed that the four sons had little or no knowledge of the job functions for which they were compensated. The court found that taxpayer’s compensation expert erroneously looked at comparable compensation to positions at manufacturing companies, which was not helpful because the taxpayer was a wholesaler. The court held that the compensation paid was not reasonable based upon: (1) the amounts and equivalency of the sons’ compensation; (2) the proportionality to their stock interests; (3) the disproportionality to the majority shareholder’s compensation; (4) the manner in which the majority shareholder dictated the amounts; and (5) the goal to reduce taxable income to minimize tax. It should be noted that the court did not challenge the compensation paid to the majority shareholder because he had proven qualifications, competency and the fact that his compensation was in the median range of the correct comparables. Pursuant to IRC Section 6662(a) and (b)(2), the court imposed penalties of 20 percent of the understatement.

Practice Point: Transupport demonstrates how important it is for corporate taxpayers to make sure they have adequate support for the compensation they pay and claimed as a deduction. To sustain a deduction, compensation paid must be objectively reasonable. Payments to insiders and family will be subject to special scrutiny. To defend yourself, make sure your files contain the evidence you will need to support the deduction. This may include: resumes of the employee, compensation studies, performance evaluations and published comparables.