IRC 162 Position Paper

Position Paper Regarding:
The appropriateness of the need for Management Compensation Studies between entities that have been awarded EDC Benefits and U.S. Domiciled Corporation

Sam G. Torolopoulos, CPA-ABV

The Purpose of this paper is to:

1. Determine if it is appropriate to classify money paid by US Domiciled Corporations (or other entity) to USVI service providers, under the guidelines of IRC §162(a) and IRC §162(a)(1) or if those payments are deemed appropriate on their face and therefore not subject to reasonableness testing under IRC§162.
2. Determine if additional consideration need be given to the fact that the party receiving payments ultimately impacts the management decision when making decisions of management fees.

In order to go through this process we must first review and stipulate to certain facts:

1. The U.S. and the USVI have what is termed as “mirror code” with the exception of IRC §934, and related sections.
2. Income reported via form K-1 from a qualified beneficiary entity of the EDC allows the VI resident partner to receive a credit against tax for this income.
3. Income reported via form K-1 from a U.S. Domiciled corporation to the same VI resident does not qualify for the credit.
4. IRC §934 does not address the issue reasonable compensation.
5. U.S. domiciled corporations are subject to IRC §162 when determining if compensation paid to its executives is reasonable.
6. Many sections of the U.S. tax code use executive compensation and management compensation or management fees interchangeably when discussing issues related to compensation such as, Controlled Group and Affiliated Service Rules.
7. U.S. Domiciled Corporations are required to file U.S. income tax returns if incorporated in the United States and\or if they conduct business in the United States regardless of where the shareholders declare their residence.
8. The Internal Revenue Code does not have separate rules for determining reasonable Compensation based on the form of entity making such payments.
9. IRC §482 regarding transfer pricing rules may provide some guidance with respect to fees paid between a US domiciled and non-US domiciled companies but is applicable to manufacturing entities and does not specifically address management fees or executive compensation.
10. In all cases where reasonable compensation is questioned the courts presume the Internal Revenue Services’ determination of reasonable compensation to be correct, which in affect places the burden of proof on the taxpayer.
11. For purposes of this discussion, we are addressing the issues of privately held businesses.

Management or Executive Compensation in order to be deductible pursuant to IRC §162 it must meet both criteria:

I.R.C. 162(a)

• Only necessary and reasonable business expenses may be deducted from business taxable income and

I.R.C. 162(a)(1)

• Permits a corporation to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered”.

The first requirement is overall statement that applies to all expenses that are deductible against gross income for any entity engaged in business activities and the second relates to personal services actually rendered. It is important to notice that the code section does not differentiate between services rendered by individuals or entities of any type. Furthermore this code section does not limit its self to certain positions in the affected entity.

The clause “for salaries or other compensation for personal services actually rendered” forms the basis for the law of reasonable compensation and effectively empowers the Internal Revenue Service (“IRS”) to scrutinize, police, and\or challenge compensation arrangements between an employer and an employee. Again this requirement is without regard to the position in question, how it is paid, or if paid to an entity.

The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.¹ The foundational issues are (1) an intent test (whether payment is in fact made for services rendered) and (2) an amount test (whether the amount of the payment is reasonable in relation to the services performed). The existence of a compensatory purpose (the intent test) can often be inferred if the amount of compensation is determined to be reasonable.² For that reason, courts focus on the reasonableness of the amount of the purported compensation.³ Courts generally do not delve into whether a compensatory purpose (intent) exists unless there is evidence that purported compensation payments, although reasonable in amount, were in fact disguised dividends.⁴ If there is evidence that the payments contain disguised dividends, the corporation must separately satisfy both the reasonableness test and the compensatory intent test.⁵ Reasonableness alone will not suffice in such situation.⁶ Courts have also relied on the intent test where (1) a taxpayer attempts to recharacterize a payment as compensation⁷ or (2) the taxpayer’s initial characterization of the payment as compensation does not comport with its substance.⁸ Reasonable compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.⁹

Again, in the above cited code, regulations, and court cases nowhere do the courts exempt management fees paid to entities for services rendered nor do they specifically exempt the service provider due to its location. The code is intentionally vague in this regard to be inclusive not exclusive.

For large, publicity held corporations, the deductibility of compensation is seldom questioned because the corporation is usually dealing at arm’s length with its employees.¹⁰ With respect to publicly traded company’s the courts have long recognized the “natural tension” that exists between management, who wants to maximize compensation and shareholders who want to maximize return on investment. However, compensation paid by a corporation whose stock is closely held must be given special scrutiny.¹¹ As the Court of Appeals for the Ninth Circuit explained in Elliotts, Inc. v. Comr.,¹² a closely held corporation will normally have an interest to characterize payments to a shareholder/employee as deductible compensation (rather than as nondeductible dividends) and the shareholder/employee and corporation are likely not to be dealing at arm’s length.¹³ The problem of determining whether a purported compensation payment is actually a disguised dividend is aggravated when a shareholder/employee is the corporation’s sole shareholder.¹⁴ An employee who is the sole shareholder not only has control over the corporation’s operations but is the only eligible dividend recipient.¹⁵

Conclusion:

Therefore, based on the above referenced code section, sub-section, regulations, and the representative court cases we conclude:

1. The courts do not distinguish between executive compensation, management compensation and:
2. The burden of proof in the determination of reasonable compensation is that of the taxpayer entity taking the deduction.
3. There is substantial guidance through the regulations and highly regarded court cases to allow for the proper determination of management fees to be paid for personal services rendered.

With respect to addressing the issue as to whether or not the fact that one of the parties has qualified for benefits under the Economic Development Program, we must consider the following:

1. The mirror VI revenue code does not provide for any exceptions under IRC §162
2. Payments made to EDC entities are considered management fees under IRC §162
3. Resident’s of the U.S.V.I. must calculate and properly report income that qualifies for the EDC credit.
4. The proper characterization of income has a material impact as to the computation and application of the EDC credit.

Therefore, it is our determination that U.S. domiciled private entities that pay management fees to qualified V.I. entities will not be exempt from the requirements under IRC §162. Such entities will be well served if a proper compensation study is used to assist management in determining reasonable compensation when negotiating fees with EDC entity.

Sam G. Torolopoulos, CPA-ABV
President
ATI Capital Group, Inc.
222 West Las Colinas Blvd. #1346 East Tower
Irving, Texas 75039

Footnotes

1. Treas. Reg. 1.162-7(a); Int'l Capital Holding Corp. & Subsidiaries v. Comr., T.C. Memo 2002-109; B & D Foundations, Inc. v. Comr., T.C. Memo. 2001-262; Haffner's Service Stations, Inc. v. Comr., T.C. Memo. 2002-38; Wagner Constr., Inc. v. Comr., T.C. Memo. 2001-160; Normandie Metal Fabricators, Inc. v. Comr., T.C. Memo. 2000-102.

2. Wagner Constr., Inc. v. Comr., T.C. Memo. 2001-160; O.S.C. & Assoc., Inc. v. Comr., 187 F.3d 1116, 23 EBC 1569 (9th Cir. 1999), cert. denied, 120 S. Ct. 1831 (U.S. 2000); Labelgraphics, Inc. v. Comr.,T.C. Memo. 1998-343, aff'd, 221 F.3d 1091 (9th Cir. 2000).

3. Wagner Constr., Inc. v. Comr., T.C. Memo. 2001-160; O.S.C. & Assoc., Inc. v. Comr., 187 F.3d 1116, 23 EBC 1569 (9th Cir. 1999), cert. denied, 120 S. Ct. 1831 (U.S. 2000).

4. Id.

5. Id.

6. Id.

7. See Simco Automotive Pump Co. v. Comr., 78 T.C.M. 106 (1999).

8. See O.S.C. & Assoc., Inc. v. Comr., 187 F.3d 1116, 23 EBC 1569 (9th Cir. 1999), cert. denied, 120 S. Ct. 1831 (2000).

9. Treas. Reg. 1.162-7(b)(3).

10. Owensby & Kritikos, Inc. v. Comr., 819 F.2d 1315 (5th Cir. 1987).

11. B & D Foundations, Inc. v. Comr., T.C. Memo. 2001-262; Herold Mktg. Assoc., Inc. v. Comr., 77 T.C.M. 1306 (1999); Haffner's Service Stations, Inc. v. Comr., T.C. Memo. 2002-38.

12. 716 F.2d 1241 (9th Cir. 1983), rev'g and rem'g T.C. Memo. 1980-282.

13. Id.

14. Id.

15. Id.