Bonuses and Accumulated Earnings Prove Troublesome
Under IRC section 162(a)(1), businesses can deduct bonuses they pay employees as reasonable compensation for services actually rendered in the current or prior years. The courts have generally applied either a single-factor independent-investor or multiple-factor test to determine the deductibility of bonuses. The courts closely scrutinize bonuses when the employee/ owner is the recipient because of the possibility of disguised dividends. IRC section 531 imposes a penalty tax on corporations that accumulate earnings for the purpose of helping an employee avoid personal income taxes by not distributing them. An excess accumulation is one that goes beyond the company's reasonable needs. According to tax regulations, a corporation can justify reasonable needs through a specific, definite and feasible plan for its eventual use of the accumulation. Haffner's Service Stations is a closely held corporation that sells oil and gas in Massachusetts and New Hampshire. The three principal officers are Haft, his father Emile and his mother Louise. Haff is the president and CEO. The bonuses in question were ones the company had paid to Emile and Louise, who were in their 80s in the years under dispute--1990 to 1992. During this period the company paid Emile and Louise total salaries of $108,575 and bonuses of $2.3 million. Haffner's allocated a small portion of the bonuses to other family businesses but had deducted the remainder on its tax return. The company has never paid dividends. In addition its retained earnings increased 61% from 1990 to 1992. In 1996 the IRS notified Haffner's of an impending deficiency under IRC section 534(0) for excess earnings accumulation. The company responded that it had been accumulating the earnings for a potential stock repurchase based on an adverse ruling in a family lawsuit. The IRS assessed deficiencies for the three years, disallowing the bonuses and imposing the accumulated earnings tax. The Tax Court ruled in favor of the IRS. Haffner's appealed to the First Circuit Court of Appeals. Result. For the IRS. The First Circuit agreed with the Tax Court that the bonuses were unreasonable based on a multiple-factor test: * Employee's qualifications--Emile and Louise had only marginal skills. * Nature, extent and scope of employee's work--Emile and Louise's work was not fundamental, substantial or all-encompassing. * Size and complexity of employer's business--the taxpayer's business was neither complex nor relatively large. * Comparison of compensation paid with company's gross and taxable income--the percentages were high, on average 7.69% of gross income and 21.73% of taxable income. …