Labels do not turn a shareholder's personal expenses into deductible compensation

Plain-English summary

A closely held corporation paid expenses for its sole shareholder, chief
executive, and president, and reported some payments as business expenses while
the shareholder reported other amounts as “Other Income.” Chief Counsel advised
that the reporting labels do not determine whether the corporation may deduct
the payments under IRC § 162. A deduction is allowed only for reasonable
compensation actually paid for services, which is a fact-specific inquiry that
must examine all payments and the surrounding circumstances. Once payments are
found nondeductible, their treatment to the shareholder also depends on their
actual character, such as a dividend, payment for property, or additional
compensation. The memorandum discusses Second Circuit and Tax Court authorities
on reasonable compensation and emphasizes close scrutiny when a controlling
shareholder sets compensation.

Ruling snapshot

• Question: How should a corporation and its sole shareholder treat
  payments for personal expenses that were reported under inconsistent labels?
• Outcome: Advice given, determine deductibility and shareholder treatment
  from the facts rather than the return labels
• Key authorities: IRC §§ 61(a)(1) and 162(a); Treas. Reg. §§ 1.162-7,
  1.162-8, and 1.162-9; Rev. Rul. 79-8

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202045012
       Release Date: 11/6/2020
       CC:ITA:2:                                             Third Party Communication: None
       POSTU-101000-18                                       Date of Communication: Not Applicable

UILC: 162.01-07

date: June 08, 2020

 to:   Jenny D. Boissonneault
       (LBI)

from: David Silber
(CC:ITA:2)

subject: -------------------------------------------------------------

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       Issue: What is the proper treatment of income adjustments on the Forms 1120 filed by
       ------------------------------------------------------------------------------------ for the taxable years ----
       ------- through ------- (“years at issue”) as well as for taxable years --------------?

       Facts: ------------ is a holding company. Subsidiary develops -----------------------------------
       --------------. ----------------- is CEO and President of ------------ and 100% shareholder. ----
       ----------- compensation for each year at issue was approximately $-----------------. This
       case would be appealable to the United States Court of Appeals for the Second Circuit
       (Second Circuit) if filed in the Tax Court or the applicable district court.

       During the years at issue ------------ made payments to --------- it characterized on its
       Forms 1120 as deductible business expenses under section 162 that --------- did not
       include in her gross income. ------------ also made separate payments to --------- it
       characterized as personal (originating from a stipend and direct payments) that ---------
       reported on her Forms 1040 as additional “Other Income,” Line 21. ------------ deducted
       these payments on its Forms 1120 as Meals & Entertainment for the years at issue.

       During the audit for the years at issue, the exam team determined that a portion of the
       claimed business expenses were the personal expenses of ---------, solely benefitting ---
       ---------. The exam team intended to disallow these amounts as business deductions to
       ------------, include them in ----------- gross income as additional income, and assert the
       civil fraud penalty on both ----------------------------.

POSTU-101000-18 2

The ------- year was subsequently included in the audit. The exam team noticed that
Stipend and others claimed business expenses that had been deducted by ------------ for
the years at issue were not deducted by ------------ in -------. Instead, these expenses
were recharacterized as personal and a Schedule M adjustment was made on ------------
----------------------tax return. --------- included them on the Form 1040 as additional “Other
Income.” In --------------------, it appears that ------------ treated these “personal expenses”
as dividends to ---------.

On -----------------, the exam team’s manager entered into a verbal settlement, whereby --
------------------------agreed to an adjustment equaling ---% of the adjustments for the
years at issue, a penalty under section 6662 to be applied to the deficiency resulting
from those adjustments, and a “no change” to the ------- taxable year. The Internal
Revenue Service (Service) prepared the Forms 4549 for the settlement, and for
consistency purposes, included the additional amounts as “Other Income” for ---------.

Taxpayers’ position: The payments made by ------------ to --------- are includable in her
gross income unless otherwise excludable by another section of the Internal Revenue
Code (Code). Section 61(a)(1) includes “[c]ompensation for services, including fees,
commission, fringe benefits, and similar items” in income. Section 1.61(a) provides that
“gross income means all income from whatever source derived, unless excluded by
law.” See also DeFabo v. Commissioner, 4 T.C. Memo 1975-282 (1975), holding that
stipends paid to a doctor were includable as gross income under section 61(a)(1).

Consistent with the treatment of the payments as income to ---------, ------------ is entitled
to a deduction for the amount paid under 162(a)(1), unless otherwise limited by another
section of the Code. See also section 1.162-7(a). The only section of the Code that
limits the deductibility of compensation is irrelevant to this case, as it only applies to
publicly held corporations. See section 162(m). Thus, the “Other Income” adjustment
must be treated as compensation paid to the employee (---------) and deductible by the
employer (------------)…had the IRS characterized the adjustment differently (e.g., as a
dividend or wages), the adjustment would have to be treated consistent with that
characterization on the returns. In the case of a dividend, ------------ would not deduct
the amount distributed and, in this case, --------- would be eligible for qualified dividend
treatment, reportable on Line 3a of her Form 1040.

LBI’s Discussion/Analysis: ------------ is not arguing that the additional amounts were
additional forms of compensation paid to --------- for efforts in running the company. -----
------------ is claiming that because the amounts were included as additional “Other
Income” the amounts must be characterized as compensation. It is clear that the
amounts paid were for the personal expenses of --------- and there was no
documentation submitted to substantiate any business purpose/nexus for the payments.
Further, ----------was clearly well compensated for the years at issue; there is no
argument that --------- was undercompensated for ----------- services. The amounts are
not compensation. The deductibility of the payments depends on their characterization
under section 162(a). The amounts paid were not ordinary and necessary expenses
POSTU-101000-18 3

paid during the years at issue to carry on the business of ------------. Whether
characterized as additional “Other Income” or not, the expenses are not deductible to ---
------------. This is also consistent with ------------------------ treatment for the years at issue
and -------. The amounts should be treated as ordinary income to --------- with no
corresponding deduction to ------------.

Law and Analysis: Section 162 provides that there shall be allowed as a deduction all
the ordinary and necessary expenses paid or incurred during the taxable year in
carrying on any trade or business.

Section 1.162-7(a) provides that 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.

Section 1.162-7(b)(1) provides that any amount paid in the form of compensation, but
not in fact as the purchase price of services, is not deductible. An ostensible salary paid
by a corporation may be a distribution of a dividend on stock. This is likely to occur in
the case of a corporation having few shareholders, practically all of whom draw salaries.
If in such a case the salaries are in excess of those ordinarily paid for similar services
and the excessive payments correspond or bear a close relationship to the
stockholdings of the officers or employees, it would seem likely that the salaries are not
paid wholly for services rendered, but that the excessive payments are a distribution of
earnings upon the stock. An ostensible salary may be in part payment for property.
This may occur, for example, where a partnership sells out to a corporation, the former
partners agreeing to continue in the service of the corporation. In such a case it may be
found that the salaries of the former partners are not merely for services, but in part
constitute payment for the transfer of their business.

Section 1.162-7(b)(2) provides that 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.

Section 1.162-7(b)(3) provides that in any event the allowance for the compensation
paid may not exceed what is reasonable under all the circumstances. 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. The
circumstances to be taken into consideration are those existing at the date when the
POSTU-101000-18 4

contract for services was made, not those existing at the date when the contract is
questioned.

Section 1.162-8 provides that the income tax liability of the recipient in respect of an
amount ostensibly paid to him as compensation, but not allowed to be deducted as such
by the payor, will depend upon the circumstances of each case. Thus, in the case of
excessive payments by corporations, if such payments correspond or bear a close
relationship to stockholdings and are found to be a distribution of earnings or profits, the
excessive payments will be treated as a dividend. If such payments constitute payment
for property, they should be treated by the payor as a capital expenditure and by the
recipient as part of the purchase price. In the absence of evidence to justify other
treatment, excessive payments for salaries or other compensation for personal services
will be included in gross income of the recipient.

Section 1.162-9 provides that bonuses to employees will constitute allowable
deductions from gross income when such payments are made in good faith and as
additional compensation for the services actually rendered by the employees, provided
such payments, when added to the stipulated salaries, do not exceed a reasonable
compensation for the services rendered. It is immaterial whether such bonuses are
paid in cash or in kind or partly in cash and partly in kind. Donations made to
employees and others, which do not have in them the element of compensation or
which are in excess of reasonable compensation for services, are not deductible from
gross income.

First issue: We realize you have asked only about the taxability of the “Other Income,”
however, all payments made to --------- from ------------ should be evaluated to determine
deductibility by ------------ under section 162. Whether a payment made to --------- by ----
------------ is deductible compensation is a question of fact. Only compensation that is
reasonable and paid for personal services actually rendered to ------------ is deductible
by ------------ under section 162. How the parties label or report the payment to the
Service does not affect the deductibility of the payment. As a result, in this case it is not
material that -----------------------reported some payments as deductible compensation
and others as “Other Income.”

There are approximately 400+ opinions (published and unpublished) addressing what is
a reasonable allowance for salaries or other compensation for personal services
actually rendered for purposes of the deduction under section 162. Because this case
is appealable to the Second Circuit if filed in district court or the Tax Court, we have
included mostly cases in the Second Circuit and the Tax Court.

In Botany Worsted Mills v. U.S., 278 U.S. 282 (1929), the United States Supreme Court
denied a deduction for claimed compensation under a predecessor to section 162
because the compensation was not reasonable. The Court stated on pp 292-293:

   We do not find it necessary to determine here whether the amounts paid
   by a corporation to its officers as compensation for their services cannot

POSTU-101000-18 5

  be allowed as ‘ordinary and necessary expenses’ within the meaning of
  section 12(a), merely because, and to the extent that, as compensation,
  they are unreasonable in amount. However this may be, it is clear that
  extraordinary, unusual and extravagant amounts paid by a corporation to
  its officers in the guise and form of compensation for their services, but
  having no substantial relation to the measure of their services and being
  utterly disproportioned to their value, are not in reality payment for
  services, and cannot be regarded as ‘ordinary and necessary expenses’
  within the meaning of the section; and that such amounts do not become
  part of the ‘ordinary and necessary expenses’ merely because the
  payments are made in accordance with an agreement between the
  corporation and its officers. Even if binding upon the parties, such an
  agreement does not change the character of the purported compensation
  or constitute it, as against the Government, an ordinary and necessary
  expense. Compare 20 Treas. Dec., Int. Rev., 330; Jacobs & Davies v.
  Anderson (C. C. A.) 228 F. 505, 506; United States v. Philadelphia Knitting
  Mills Co. (C. C. A.) 273 F. 657, 658; and Becker Bros. v. United States (C.
  C. A.) 7 F. (2d) 3, 6.

  In the light of this principle it is clear that the findings do not show, as a
  matter of necessary inference resulting as a conclusion of law, that the
  amount paid the directors in excess of the $782,083.33 allowed by the
  Commissioner, constituted part of the ordinary and necessary expenses of
  the Mills. On the contrary, as this amount so greatly exceeded the
  amounts which, as a matter of common knowledge, are usually paid to
  directors for their attendance at meetings of the board and the discharge
  of their customary duties, and was much greater than the amounts that
  had been paid in prior years, and as there is no showing as to the
  amounts paid the individual directors, in addition to the salaries of $9,000
  which each received-presumably for his services as an executive officer or
  department manager-or as to the nature, extent or value of their services,
  the findings raise a strong inference that the unusual and extraordinary
  amount paid to the directors was not in fact compensation for their
  services, but merely a distribution of a fixed percentage of the net profits
  that had no relation to the services rendered.

In Rapco, Inc. v. Commissioner, 85 F.3d 950 (2nd Cir. 1996), the Second Circuit
affirmed the Tax Court’s determinations (Rapco, Inc. v. Commissioner, 69 T.C.M. 2238
(1995)) that income tax was owned by the corporation as a result of the deduction of an
unreasonable amount of compensation paid to its president. The Second Circuit
provided at pp 954-955 that the factors to be considered are as follows:

  What factors are to be considered in making a reasonableness
  determination is a question of law, which we review de novo; but, the
  ultimate determination, based on those factors, that the compensation
  paid was “reasonable” is, at most, a mixed question of law and fact, which

POSTU-101000-18 6

 we review only for clear error. Cf. Bausch & Lomb Inc. v. Commissioner,
 933 F.2d 1084, 1088 (2d Cir.1991); see also Owensby & Kritikos, Inc. v.
 Commissioner, 819 F.2d 1315, 1323–24 (5th Cir.1987) Owensby &
 Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323–24 (5th Cir.1987)
 (reasonableness of compensation is a question of fact); Elliotts, Inc. v.
 Commissioner, 716 F.2d 1241, 1245 (9th Cir.1983) (same). The taxpayer
 has the burden of proving that the IRS’s determination of reasonable
 compensation is incorrect. See Tax Court Rule 142(a); Welch v.
 Helvering, 290 U.S. 111, 115, 54 S. Ct. 8, 9, 78 L.Ed. 212 (1933). The
 taxpayer’s burden of showing that it is entitled to a larger deduction for
 compensation than allowed by the IRS is particularly heavy when that
 compensation is paid to a shareholder-officer. See Pepsi–Cola Bottling
 Co. v. Commissioner, 528 F.2d 176, 179 (10th Cir.1975).

 This Court has had no occasion to enunciate comprehensively the factors
 to be considered in evaluating the reasonableness of employee
 compensation under 26 U.S.C. § 162(a)(1). The Ninth Circuit, however, in
 Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir.1983), exhaustively
 catalogued and analyzed the relevant considerations. See also Owensby
 & Kritikos, 819 F.2d at 1322–25 (discussing some factors). In Elliotts, the
 Ninth Circuit isolated five broad categories: (1) Employee’s role in the
 company: including the employee’s position, hours worked, and duties
 performed, plus any special duties or role (such as personally
 guaranteeing corporate loans); (2) External comparison with other
 companies: salaries paid to comparable employees in similar companies;
 (3) Character and condition of the company: including the sales, net
 income, capital value, and general economic fitness of the company; (4)
 Potential conflicts of interest: ability to “disguise” dividends as salary,
 particularly when the employee is the sole or majority shareholder, and/or
 where a large percentage of the compensation is paid as a “bonus”; and,
 (5) Internal consistency in compensation: consistency of the compensation
 system throughout the ranks of the company. Elliotts, 716 F.2d at 1245–
 48.

 No one factor is dispositive. See id. at 1245; Owensby & Kritikos, 819
 F.2d at 1323. Furthermore, the court should assess the entire tableau
 from the perspective of an independent investor—that is, given the
 dividends and return on equity enjoyed by a disinterested stockholder,
 would that stockholder approve the compensation paid to the employee?
 See Elliotts, 716 F.2d at 1245.

 We find that the Elliotts’ factors, examined from the perspective of an
 independent investor, are an appropriate standard to evaluate the
 reasonableness of employee compensation. These factors adequately
 balance the company’s financial fitness and role in the market, and the
 employee’s responsibility for that role. They also require a suitable

POSTU-101000-18 7

  comparison of the employee’s compensation to other employees in the
  same company, and similar employees in analogous companies—sturdy
  benchmarks for determining the reasonableness of an employee’s reward.
  And, these considerations properly patrol a company’s ability to substitute
  salary for dividends by recognizing, in the first place, a shareholder-
  officer’s temptation to do so, and, then, by focusing on the disinterested
  investor’s perspective.

In Dexsil Corp. v. Commissioner, 147 F.3d 96 (2nd Cir. 1998), the Second Circuit
determined that the Tax Court’s failure to assess the reasonableness of compensation
paid to Lynn, president of Dexsil, from the perspective of a hypothetical or independent
investor was erroneous as a matter of law. Accordingly, it vacated and remanded the
Tax Court’s opinion for reconsideration. The Second Circuit directed the Tax Court to
make specific findings regarding the following questions: (1) whether a hypothetical
investor would accept the compensation paid to Lynn; (2) whether Lynn was paid
according to a long-standing and consistently applied contingent compensation formula,
and if so, whether his salary was reasonable in light of this formula; (3) whether Lynn’s
compensation compared favorably with the compensation paid by similar companies for
comparable services, given the many roles Lynn played at Dexsil; and (4) whether, after
reconsideration of these factors, the balance of factors has shifted in favor of Dexsil
such that it has met its burden of proving that Lynn’s compensation was reasonable.

In Appeal of Gustafson Mfg. Co., 1 B.T.A. 508 (1925) the United States Board of Tax
Appeals provided that under section 234(a) of the Revenue Act of 1918 (a predecessor
of section 162) a corporate taxpayer may not deduct as an ordinary and necessary
expense more than a reasonable amount for compensation for its president. The Board
of Tax Appeals refuted the Taxpayer’s contention that the Commissioner had no
authority to determine what was a reasonable amount of compensation. The Board of
Tax Appeals stated that “the Commissioner not only has the authority but it is his duty to
determine under all the facts obtainable the reasonableness or unreasonableness of
deductions by a corporate taxpayer of compensation paid.” Section 234(a) of the
Revenue Act of 1918 provided:

   That in computing net income there shall be allowed as deductions all
   ordinary and necessary expenses paid or incurred during the taxable year
   in carrying on any trade or business, including a reasonable allowance for
   salaries or other compensation for personal services actually rendered * *
   *

In Geiger & Peters, Inc. v. Commissioner, 27 T.C. 911 (1957), the Tax Court found that
the amounts claimed as deductions for officers’ salaries were reasonable under section
23(a), Internal Revenue Code of 1939 (a predecessor of section 162). The Tax Court
stated at pp 920-921:

  The second issue presented is whether the amounts of salary paid or
  credited to the accounts of Harold and Oscar, respectively, were
  ‘reasonable’ within the meaning of section 23(a)(1)(A), Internal Revenue

POSTU-101000-18 8

  Code of 1939. The burden of proving reasonableness is upon petitioner.
  Botany Worsted Mills v. United States, 278 U.S. 282. It is well settled that
  the question of what constitutes reasonable compensation to a specific
  officer of a corporation is essentially a question of fact to be determined by
  the peculiar facts and circumstances of each particular case. Miller Mfg.
  Co. v. Commissioner, 149 F.2d 421. Among the factors which are to be
  considered, but not necessarily with equal importance, are the type and
  extent of services rendered by the employee; the scarcity of qualified
  employees for the particular position; the volume and amount of the
  taxpayer’s business, including its special or peculiar characteristics, if any;
  the prevailing compensation paid to employees performing similar
  services in other comparable enterprises; and the general economic
  conditions. Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115.
  See 4 Mertens, Law of Federal Income Taxation sec. 25.69.

In Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 61 T.C. 564 (1974), aff’d 528
F.2d 176, (10th Cir., 1975) the sole executive officer of a corporation had been
compensated for the years in issue under a corporate resolution which had remained
unchanged for 12, 13, and 14 years, respectively, and which was no longer realistic
because of related changing factors and circumstances. In this case, the compensation
was contingent compensation. The Tax Court disagreed with both the taxpayer’s and
the Service’s determination of the reasonable compensation deductible under section
162 of the Internal Revenue Code of 1954 and made its own determination of what was
reasonable.

In Switz v. Commissioner, T.C. Memo. 1979-162 (April 24, 1979), the taxpayer rented
property from a bank the taxpayer then subleased to his corporation. The taxpayer
charged his corporation more rent than was due under the lease with the bank.
Taxpayer’s corporation attempted to deduct this amount under 162 as rent, or
alternatively as compensation from the corporation paid to the taxpayer. The Tax Court
agreed with the Service that these payments are not deductible since they were neither
paid nor intended as compensation. The Tax Court stated that:

  The test of deductibility for compensation payments is whether they are
  reasonable and are in fact paid purely for services. Section 1.162-7(a),
  Income Tax Regs. The payment must be paid and intended as
  compensation. Jefferson Block & Supply Co. v. Commissioner, 59 T.C.
  625, 633–634 (1973), affd. 492 F. 2d 1243 (6th Cir. 1974). Whether this
  intent has been shown is a factual question to be decided on the basis of
  the particular facts and circumstances of the case. Electric & Neon, Inc. v.
  Commissioner, 56 T.C. 1324, 1340 (1971), affd. without opinion, 496 F. 2d
  876 (5th Cir. 1974). The burden of proof is on petitioner, Welch v.
  Helvering, 290 U.S. 111 (1933).

Second Issue: Once it is determined what payments made to --------- by ------------ are
not deductible under section 162, regardless as to their characterization by the parties,
POSTU-101000-18 9

the question becomes how these excess nondeductible payments should be taxed. Are
the payments gifts, dividends, or just additional compensation that is not deductible to --
------------ but taxable at ordinary income tax rates to ---------. This question is also fact
specific and addressed by not only section 1.162-7 but also sections 1.162-8 and -9.
You have indicated that in -------, the “Other Income” was taxed at ordinary income tax
rates to ---------, but this income was characterized as dividends in --------------------. ------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

I found only 16 cases interpreting section 1.162-8. Most of these cases also interpret
section 1.162-7. There are approximately 63 cases addressing the treatment of
bonuses under section 1.162-9, most of which also address section 1.162-7. Since this
case does not involve bonuses, I did not provide cases focused on bonuses. Please
note, however, that Elliot discussed in Rapco, supra, and Caledonia and Garrison
discussed below, do involve bonuses.

I set forth Caledonia and Garrison below because Caledonia would have been
appealable to the Second Circuit and Garrison is a T.C. opinion. Both cases discuss in
detail factors to be considered in determining the nature of excess compensation paid
from a closely held company to shareholders. I also included a revenue ruling
discussing the treatment of excess compensation not deductible under section 162 as
dividends.

The District Court in Caledonian Record Pub. Co., Inc. v. U.S., 579 F. Supp. 449 (D.
Vermont 1983) analyzed excess compensation payments to multiple family members
having an interest in the corporation. With respect to excess payments to a controlling
shareholder, the District Court provided at pp 460-461:

     When a case involves a closely held corporation where the controlling
     shareholder-executives set their own compensation, close scrutiny is
     necessitated to ascertain whether such alleged compensation is in fact a
     distribution of corporate profits. Levenson and Klein, Inc. v.
     Commissioner, 67 T.C. 694, 709 (1977); Perlmutter v. Commissioner, 373
     F.2d 45, 47 (10th Cir.1967).

     An ostensible salary paid by a corporation may be a distribution of a
     dividend on stock. This is likely to occur in the case of a corporation
     having few shareholders, practically all of whom draw salaries. If in such
     a case the salaries are in excess of those ordinarily paid for similar
     services and the excessive payments correspond or bear a close
     relationship to the stockholdings of the officers or employees, it would
     seem likely that the salaries are not paid wholly for services rendered, but
     that the excessive payments are a distribution of earnings upon the stock.

POSTU-101000-18 10

   26 C.F.R. § 1.162–7(b)(1). This regulation summarizes a collection of
   cases which over the years have determined that ostensible salaries paid
   to controlling shareholders of corporations are in reality disguised dividend
   payments. The advantage of such excessive salary payments is clear;
   compensation or wages represent a deductible expense to the corporation
   while dividend payments do not. The fact that a closely held corporation
   does not make regular distributions of profits is an additional warning that
   excessive compensation to a shareholder/employee may in fact be a
   disguised dividend. Mayson Mfg. Co. v. Commissioner, supra, 178 F.2d
   at 119; Rev. Rul. 79–8.

   The failure of a closely held corporation to pay more than an insubstantial
   portion of its earnings as dividends on its stock is a very significant factor
   to be taken into account in determining the deductibility of compensation
   paid by the corporation to its shareholder/employees. Rev. Rul. 79–8; see
   Mayson Mfg. Co. v. Commissioner, supra, 178 F.2d at 119.6

In Garrison v. Commissioner, 52 T.C. 281 (May 15, 1969), the principal stockholder-
officer-employee of a corporation received a purported $40,000 bonus for his services.
The bonus was authorized and paid after the corporation had determined to liquidate,
ceased doing business, and sold its operating assets. On audit of the corporation's
return, the Service disallowed $15,000 of the bonus as excessive compensation and the
corporation conceded the disallowance. The Tax Court held that $15,000 constituted a
distribution in complete liquidation in respect of the stockholder-officer-employee's stock
within the meaning of section 331(a) of the Internal Revenue Code of 1954. The Tax
Court explained at pp 284-285 that:

   Various unsuccessful attempts have been made to characterize amounts
   disallowed as excessive compensation as nontaxable receipts in the
   hands of the recipients. Thus, such amounts have been refused the
   status of gifts. Lengsfield v. Commissioner, 241 F.2d 508 (C.A. 5, 1957);
   Smith v. Manning, 189 F.2d 345 (C.A. 3, 1951); Stanley B. Wood, 6 T.C.
   930 (1946). Similarly, such payments have not been considered
   repayments of loans. D. J. Jorden, 11 T.C. 914 (1948). Likewise, an
   attempt to classify such a payment by one subsidiary corporation to a
   second subsidiary corporation as a constructive dividend to the parent and
   a contribution to capital of the second subsidiary has also failed. Sterno
   Sales Corporation v. United States, 345 F.2d 552 (Ct. Cl. 1965); cf.
   Zeunen Corporation v. United States, 227 F. Supp. 952 (E.D. Mich. 1964).

   A careful reading of these cases reveals that excessive compensation
   does not, as a matter of law, retain that characterization for tax purposes
   in the hands of the recipient. Nor must it necessarily be considered
   something other than compensation. Neither the label initially affixed by
   the taxpayer nor the failure of the respondent to provide an alternative

POSTU-101000-18 11

   label for the disallowed payment is conclusive. The touchstone for
   decision is a factual determination as to the actual nature of the payment
   in question under all the circumstances, free from any compulsory
   inhibitions stemming from the designations of the parties. As the Court of
   Appeals stated in Lengsfield v. Commissioner, supra:

   Whether or not a corporate distribution is a dividend or something else,
   such as a gift, compensation for services, repayment of a loan, interest on
   a loan, or payment for property purchased, presents a question of fact to
   be determined in each case. * * * (See 241 F.2d at 510.)

   Respondent's regulations recognize the factual foundation for such a
   determination in the case of distributions by an ongoing corporation. Secs.
   1.162-7(b)(1) and 1.162-8, Income Tax Regs. We perceive no valid
   reason for not applying the rationale of those regulations in a situation
   involving the liquidation of a corporation. Cf. Robert Gage Coal Co., 2
   T.C. 488, 500-502 (1943); Jas J. Gravely, 44 B.T.A. 722, 728 (1941). The
   standard to be applied is not unlike the ‘net effect’ test employed in
   determining whether distributions are essentially equivalent to a dividend.
   Cf., e.g., Woodworth v. Commissioner, 218 F.2d 719 (C.A. 6, 1955),
   affirming a Memorandum Opinion of this Court; Flanagan v. Helvering,
   116 F.2d 937 (C.A.D.C. 1940), affirming a Memorandum Opinion of this
   Court; see Levin v. Commissioner, 385 F.2d 521, 524 (C.A. 1, 1967),
   affirming 47 T.C. 258 (1966).

Rev. Rul. 79-8, 1979-1 C.B. 92, holds that the failure of a closely held corporation to pay
more than an insubstantial portion of its earnings as dividends on its stock is a very
significant factor to be taken into account in determining the deductibility of
compensation paid by the corporation to its shareholder-employees. Conversely, where
after an examination of all of the facts and circumstances (including the corporation's
dividend history), compensation paid to shareholder-employees is found to be
reasonable in amount and paid for services rendered, deductions for such
compensation under section 162(a) will not be denied on the sole ground that the
corporation has not paid more than an insubstantial portion of its earnings as dividends
on its outstanding stock.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-4643 if you have any further questions.