MLR

Court denies half of bonus as deductible compensation

Categories:

An eye surgeon who had received a $2 million bonus in 2007 was told by the U.S. Tax Court that half of it was unreasonable compensation.

Dr. Afzal Ahmad was president and 100 percent shareholder of Midwest Eye Center, an ophthalmology surgery and care center practice with four locations. The center, organized as a C corporation for tax purposes, had paid him the bonus.

He held many positions for the business, including surgeon, chief executive officer, chief operating officer and chief financial officer. These various positions required him to perform different managerial tasks.

During 2007, Ahmad was paid total compensation of $2.78 million, of which $2 million was paid out in the form of a bonus. All of the bonus money was paid in November and December 2007 in four separate checks of $500,000 each.

Ahmad’s workload increased quite a bit in 2007 because one surgeon quit, and Ahmad had to take over that surgeon’s scheduled surgeries during the second half of the year. Because another surgeon had a reduced workload, Ahmad also had to take over some of that surgeon’s responsibilities.

On Ahmad’s corporate income tax return for 2007, $2.78 million was deducted as officer compensation.

The U.S. Tax Court agreed with the IRS, disallowing $1 million of the bonus as unreasonable compensation (Midwest Eye Center, S.C. v. Commissioner, T.C. Memo. 2015-53, March 23, 2015).

IRS Code Section 162 deals with this issue and “allows taxpayers to deduct ordinary and necessary expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered.” This means compensation is deductible only if it is:

  • Reasonable in amount
  • Paid or incurred for services actually rendered

Whether amounts paid as wages are reasonable compensation for services rendered is a question decided on the basis of the facts and circumstances of each case.

Some IRS published rules and some court cases conclude that, to determine reasonable compensation, taxpayers must look at factors other than return on equity. They have to look at what other similar professionals are earning in comparison to their overall compensation package.

Ahmad produced no evidence of comparable salaries. Instead, he said that there are no like enterprises or similar circumstances with which to compare.

Ahmad felt he was entitled to the large compensation amount because of the many different administrative hats he wore for his business.

The burden of proof was on Ahmad to show that the amount paid to him was not unreasonable. The doctor provided no such proof to the court and therefore was denied the deduction for the $1 million.