Opinion ID: 489299
Heading Depth: 2
Heading Rank: 5

Heading: Employment Under Work Agreements

Text: 47 The taxpayers note that both men were paid in accordance with work agreements originally executed several years before the years at issue, and according to the taxpayers, this fact adds credence to their position that the compensation paid was reasonable. Under the work agreements, both men received a base salary from each corporation, an incentive bonus tied to corporate sales, and a discretionary bonus. As noted previously, the bulk of the compensation paid to the individual taxpayers was in the form of incentive or discretionary bonuses, which is generally considered contingent compensation. The Treasury Regulations state: 48 The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid. 45 49 In general, because it is speculative, contingent compensation may exceed what would have been paid on a fixed and definite basis. 46 And contingent compensation paid under a longstanding arm's length agreement will usually be upheld even if an incentive formula results in greater compensation than the parties anticipated at the time they entered into the contract. 47 In such a case, the trial court should focus not on the reasonableness of the actual amount paid, but rather on the reasonableness of the incentive formula at the time the parties entered into the agreement. 48 50 We note that the Tax Court questioned whether an incentive bonus tied to company performance is needed for an employee who is also a shareholder. Apparently, the argument is that such an employee already has sufficient incentive to make the business successful because as a shareholder he will receive the profits of the business anyway. 49 This argument, however, misses the economic realities of the corporate form as taxed under the internal revenue code. For compensation purposes, the shareholder-employee should be treated like all other employees. If an incentive bonus would be appropriate for a nonshareholder-employee, there is no reason why a shareholder-employee should not be allowed to participate in the same manner. In essence, the shareholder-employee is treated as two distinct individuals for tax purposes: an independent investor and an employee. If he uses his role as an investor improperly to influence his compensation, the compensation will likely be declared unreasonable. On the other hand, his status as a shareholder should not be used to prohibit him from receiving the appropriate return on this labor, and this return may well include an incentive bonus. 50 Any error committed by the Tax Court in questioning the need for an incentive provision in the work agreements of Mr. Owensby and Mr. Kritikos was, however, harmless. The record is clear that the Tax Court concluded that the existence of the work agreements with their incentive provisions provided little insight with respect to the reasonableness of the total compensation paid. As we explain below, this conclusion is correct. 51 As noted above, we recognize that the existence of a reasonable, longstanding, consistently applied compensation plan negotiated at arm's length often provides evidence that the compensation paid pursuant to that plan was reasonable. In the present case, the negotiations between the corporations on the one hand and Mr. Owensby and Mr. Kritikos on the other were never at arm's length; together, Mr. Owensby and Mr. Kritikos controlled the board of directors of each of the corporations. 51 Nonetheless, the incentive provisions in the work agreements were apparently reasonable when negotiated. Although this constitutes evidence that the incentive bonus portion of the compensation paid was reasonable, 52 it is far from dispositive on the broader question presented by this case: whether the total compensation was reasonable. Indeed, the value of this evidence is diminished significantly by the fact that Mr. Owensby and Mr. Kritikos each received from the corporations in the form of discretionary bonuses, $250,000 in 1978 53 and $192,500 in 1979. Given that Mr. Owensby and Mr. Kritikos together exerted substantial influence over these discretionary bonuses, these amounts were not the result of a longstanding compensation formula and could hardly be considered contingent compensation in the fullest sense of that term. Additionally, such substantial bonuses declared at year-end when the earnings of a business are known usually indicate the existence of disguised dividends. 54 This is even more true when, as here, the corporation has a history of distributing as compensation to its shareholder-employees the bulk of its profits. 55 52 The taxpayers have also argued that the longstanding existence of work agreements is relevant for another reason. In 1976 and 1977, the Commissioner audited the taxpayers, and declared no deficiency. The taxpayers contend that the Commissioner's acceptance of the compensation paid in those years as reasonable constitutes evidence that the compensation paid in the years at issue was also reasonable. According to the taxpayers, this follows because the compensation during the entire period was calculated under identical work agreements. The Tax Court, however, properly declined to assign this fact significant probative value. By accepting a practice in an audit, the Commissioner does not necessarily approve that practice for use in the future. 56 And contrary to the position of the taxpayers, that the Commissioner chose not to assert deficiencies following the previous audit does not necessarily indicate that the IRS accepted the manner in which compensation was determined. Rather, it merely indicates that the IRS concluded that it would not be worthwhile to assert that the amount of compensation paid was unreasonable. 57 Although in certain cases, reliance on compensation practices previously allowed by the Commissioner may show good faith, it is not decisive in determining reasonableness. 53 For these reasons, we conclude that the existence of work agreements provides little, if any, evidence in this case that the total compensation paid to the shareholder-employees was reasonable.