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The United States Tax Court found that most of the compensation paid to the sole shareholder of a radio station was not reasonable under U.S. Tax Code Section 162.

Tax Court Decides on Reasonable Compensation Case

  • 5/1/2013

Tax Court Decides on Reasonable Compensation Case

The United States Tax Court has found that most of the compensation paid to the sole shareholder of a corporation, who served as general manager of several radio stations, was not reasonable under U.S. Tax Code Section 162. Included in its decision were “catch up payments” for prior years in which the shareholder had been under-compensated.

The Tax Court found that an appeal in this case would lie to the Ninth Circuit Court of Appeals, which uses several factors to determine the reasonableness of compensation: the employee’s role in the company, comparison with other companies, character and condition of the company, potential conflicts of interest, internal consistency of compensation, and whether an independent investor would be willing to compensate the employee as he was compensated. No single factor is determinative, the court found.


Approximately 30 years ago, an individual organized a corporation and purchased several radio stations. The person was the sole shareholder of the corporation and served as its president, chief financial officer, and general manager of the stations. Among his duties, he supervised employees, planned programming, negotiated with lenders, participated in sales meetings, and communicated with outside advisors, such as accountants and lawyers.

The corporation subsequently sold some of its assets, including one of the radio stations. The transactions generated approximately $18 million. On its return, the corporation claimed a deduction of $6.8 million in compensation paid to the shareholder/general manager. The IRS disallowed $6 million of the claimed deduction and imposed an accuracy-related penalty.

Court’s analysis

The court found the shareholder was the most valuable employee of the corporation. The shareholder was actively involved in managing the daily activities of the stations and his involvement in the sale negotiations resulted in a higher purchase price.

Experts testified on behalf of the corporation and the IRS. The experts differed in their analysis and comparisons of the compensation paid to the shareholder in contrast to compensation paid to other station owners. The experts agreed that the shareholder was underpaid before the sale, the court found.

The court further found that before the sale, the corporation had seen declining profits. The court also found that the shareholder’s compensation was not paid under a consistently applied program.

In addition, the court found that a reasonable investor would expect to receive a return on his initial investment and would not approve of a salary package that depleted the corporation's assets without paying the investor. In this case, the court found that the corporation had retained sufficient earnings to satisfy an investor after the shareholder’s compensation was paid.

The court concluded, on balance, that the shareholder’s compensation was not reasonable for the tax year in dispute, and the corporation could not deduct the entire claimed amount. The shareholder’s reasonable compensation, the court found, was his fixed salary of $199,200 plus $461,200, for each of four years the shareholder was underpaid. The court also upheld the accuracy-related penalty, finding that the corporation had not acted with reasonable cause and in good faith.

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