By Reed Tinsley, CPA,CVA, CFP, CHBC
The Tax Court recently held that a $2 million bonus paid by an eye surgery center to its head surgeon and sole shareholder was not reasonable compensation. The court rejected the taxpayer’s argument that the payment, which resulted in a $50,434 net operating loss, was reasonable because of an increase in the doctor’s workload and responsibilities. [Midwest Eye Center, S.C. v. Comm’r, T.C. Memo. 2015-53]
Midwest Eye Center, S.C. (“Midwest”) was an eye surgery and care center, operating four different locations and employing around 50 employees during 2007. Dr. Afzal Ahmad was the C corporation’s president, medical director, 100 percent shareholder, and also its CEO, COO, and CFO. On top of the various managerial tasks these positions required, Dr. Ahmad was an active surgeon in the practice and received a salary of $30,000 every other week, and also received a substantial bonus at the end of each year.
In June 2007, Dr. Ahmad’s workload increased dramatically when one of Midwest’s busier surgeons quit unexpectedly and Dr. Ahmad was required to take over his prescheduled patients. Additionally, Midwest’s only other retinal specialist reduced her workload, requiring Dr. Ahmad to take on many of her surgeries as well. Dr. Ahmad received four bonus payments totaling $2,000,000 toward the end of 2007. On its 2007 Form 1120, Midwest deducted $2,780,000 for Dr. Ahmad’s salary and bonus compensation. The IRS determined that part of the bonus was really a disguised dividend, disallowing $1,000,000 of the claimed deduction.
Analysis by the Court
Compensation is deductible as a trade or business expense if the amount is reasonable (Code Sec. 162(a)(1)). Taxpayers may deduct bonuses paid to employees as additional compensation, provided the bonus combined with the employee’s salary does not exceed a reasonable compensation for the services actually rendered (Reg. Sec. 1.162-9). Amounts that would ordinarily be paid for like services by like enterprises under like circumstances are reasonable compensation (Reg. Sec. 1.162-7(b)(3)).
Midwest argued that there were no “like enterprises” under “like circumstances” from which to draw comparable salaries, instead pointing to several other reasons why Dr. Ahmad’s large bonus was reasonable. Midwest pointed to his increased workload during 2007 and the various roles he performed contending the extent of Dr. Ahmad’s duties, and the associated income he produced for the company, sufficiently justified the large bonus it paid him in 2007.
However, the Tax Court noted that Midwest failed to provide a methodology showing how Dr. Ahmad’s bonus was determined in relation to those responsibilities. Midwest did not explain how the amount of the bonus was determined and why it was divided into four payments, nor did Midwest explain how the increased billings translated to bonus payments. Absent these explanations, the court could not find suitable evidence to show that the full $2 million bonus was reasonable.
Because Midwest could not show the bonus payment was reasonable, the Tax Court sustained the IRS’s notice of deficiency, disallowing Midwest a deduction for $1 million of Dr. Ahmad’s compensation.
Many reasonable compensation cases are decided under the “independent investor test, “ which asks whether an independent investor would be willing to compensate the employee as he was compensated. Courts using this test often look to other companies in the area for a suitable comparison of the employee’s compensation, reasoning an investor would be satisfied if the compensation was similar to that of employees performing analogous services in analogous businesses. Because there were no comparable businesses in Midwest’s region from which the court could analyze similar employee compensation, the independent investor test couldn’t be used.