Compensation paid by a business, whether a corporation, limited liability or sole proprietorship must be “ordinary and necessary” to be deductible for corporate income tax purposes. If such compensation does not meet the “ordinary and necessary” standard, or if the total amount of compensation is unreasonable, such excess compensation will be denied deductibility. (Doesn’t it make you wonder how some of these salaries paid to CEOs of major corporations and hedge funds can be deductible as ordinary and necessary?)

Generally, one would think that the IRS would question only excess compensation in the ordinary and necessary context. However, two scenarios exist where the IRS does challenge deductions when the compensation is not of a sufficient amount.

The first, and likely more frequent, challenge is in the Subchapter-S context. Frequently, the owners of a Subchapter-S corporation decide to pay themselves a very low salary, with the excess profit being taxed as a Subchapter-S distribution. (A Subchapter-S distribution is not subject to employment taxes, and thus can effect a sizeable tax savings to the shareholders.) Another scenario is for a family member to work without compensation, thus increasing the taxable income available for distribution. The IRS, pursuant to §1366(e) of the Internal Revenue Code, is authorized to make adjustments to reflect the value of services or capital furnished to a Subchapter-S corporation by a family member of a shareholder.

The other scenario arises where couples work together in their business, whether a commercial shop or trade, farming operation or professional practice. Sometimes, both spouses pull the same amount of salary out the business, while other couples shift as much, or all, owners’ compensation to only one of the spouses. Shifting the compensation primarily to one of the spouses is generally done to minimize employment taxes, as the income tax will remain the same under either scenario if both spouses file a joint income tax return.

A recent Tax Court decision sheds light on the unintended consequences of shifting compensation primarily to one spouse. In Francis v. Commissioner, the wife performed services and received total compensation for the year in the amount of $1,998 in wages from the business owned and operated by the husband. The business maintained an accident and health plan for its employees, which plan reimbursed employees for health insurance costs and medical expenses. While there is a written agreement between the business and the wife, the agreement did not require, or set forth, the number of hours the wife was to work or her work schedule. Moreover, there were no records of hours actually worked or a description of the services performed.

The wife submitted a medical reimbursement claim to the health plan for $9,502, of which $5,571 was for premiums on a joint private health insurance policy solely for the wife’s husband, who owned the business. The wife received the total amount of the requested reimbursement, and when coupled with her wages, resulted in total compensation of $11,500 for the tax year at issue. On the wife’s and her husband’s joint tax return that year, the couple deducted $9,502 as an employee benefit plan expense. The IRS determined that the medical expenses were not deductible under the Internal Revenue Code under the facts presented because the compensation to which the deduction relates was not reasonable in amount.

The Tax Court went on to further explain that ordinary and necessary business expenses that are deductible under the Code include the reimbursement of employee benefit plan expenses for expenses an employee pays or incurs. Continuing, the Tax Court added that employee benefit plan expense reimbursements are deductible if (i) they are paid to a bona fide employee, (ii) they are an ordinary and necessary expense, (iii) the amount is substantiated; (iv) the amount deducted was reasonable in amount; and (v) the payment was in fact purely for services.

The Tax Court held that, even assuming that the wife was a bona fide employee, the taxpayers failed to prove that any compensation to the wife in excess of $1,998 was reasonable in amount given that there was no documentation of hours and time worked.

In our practice, a number of client consultations, it has been requested that one spouse be listed as a shareholder or in some other capacity, although they will participate “in name only,” and that the other spouse will operate the company. Quite often, if not the overriding majority of instances, the purpose is to have the business qualify as a minority-owned or woman-owned business. While the requirements for government certifications require that the minority or woman not only own a majority of the stock or membership interests, it is also required that such individual actively manage the business.

Although this Tax Court decision is unrelated to certifications, it nonetheless reinforces what we have been advising our business clients for years: the substance of the transaction, not its form, will be found to be controlling. Thus, whether in a context of a benefit plan or a minority certification program, the need to comply with regulations are paramount, lest your planning ends up costing you substantial, and very real, dollars.

Unfortunately, the couple in the Francis case could have avoided the outcome with a little preplanning and documentation. Though there is no way to determine the motivation for structuring their transaction, it was likely that tax avoidance was one, and could, with some planning, have been achieved. In planning for your business, as in this instance, it isn’t always the dollar amount that can cause the problem.