Reasonable Compensation for Law Firms and Attorneys

A question that arises repeatedly in professional service firms is what constitutes reasonable compensation for employee-owners. For many firms, no single operating expense category impacts the bottom-line enterprise profit as much as the compensation paid to the employee-owners of the enterprise. Clearly, an expense that is discretionary to the owner in terms of its magnitude, timing and method of payment, may represent not only compensation for services rendered, but may also be a disguised dividend or a distribution of profits. The amount of profits paid as compensation determined to be “reasonable” for tax reporting purposes can easily be manipulated by adjusting the compensation paid within the ownership group.

This article is intended to provide some fundamental guidance for attorneys and law firms whenever employee-owner compensation is at issue. In many instances, this focus will relate to ownership decisions regarding the overall allocation and character of enterprise profits, but the same concepts and analytical framework can be of benefit in the assessment of reasonable compensation for other purposes, such as the valuation of a non-compete agreement and in the segregation and measurement of personal/professional versus enterprise goodwill for dissolution of marriage purposes in jurisdictions where this aspect is in play. (See Identifying and Measuring Personal Goodwill in a Professional Practice, by Mark O. Dietrich, CPA/ABV, AICPA CPA Expert, Spring 2005.) Another emerging area where these principles are often applied is in the evaluation of excess or inadequate compensation challenges by the Internal Revenue Service, with respect to closely held C corporations or Subchapter S corporations, respectively. The issue with S corporations paying too little in wages to the owners to allow them to take a larger share of enterprise profits as distributions not subject to employment taxes has received significant recent attention from the Internal Revenue Service on behalf of the Social Security administration. This article provides guidance on what factors would be considered in determinations of reasonable compensation for this purpose.

Employee-owners' Compensation

Employee-owners' compensation is also often evaluated closely for business valuation purposes because the overstatement of compensation for these individuals can lead to an understatement of the value of the business enterprise within the application of several commonly used valuation methodologies. In these instances, the ultimate opinion of enterprise value can turn on the ability to support compensation for the controlling owners or professional practitioners. The normalized expense that is deducted should represent the compensation that would be paid to the practitioner in an arm's-length arrangement for the duties and services performed.

Reasonable Compensation

The following general characteristics should be considered in addressing reasonable compensation determinations:

• Experience of the owner/practitioner;
• Hours worked on a daily or periodic basis;
• Responsibilities of the position;
• Primary and ancillary duties performed;
• The age of the owner/practitioner;
• Nature of the business/professional practice;
• Geographic setting of the business/professional practice;
• Demographic characteristics of the area served by the enterprise/professional practice; and
• Sustainable revenues of the practice.

The term “reasonable compensation” is actually derived from Section 162(a) of the Internal Revenue Code. Section 162(a) provides for a corporation to deduct as a business expense “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Although tax courts have frequently addressed the reasonable compensation issue, divorce courts have not routinely devoted as much attention. The application of these concepts to determinations of reasonable compensation generally should not be understated.

Often, the determination of reasonable compensation levels among practitioners is critical to the harmony and long-term success of the enterprise. At the same time, these decisions can be the most difficult to make. The goal is to set the respective salaries for each individual to an amount that is on par with what someone would be paid to perform the same services and duties, broadly defined, as the current manager/owner does. To determine a fair salary, one needs to determine what a hypothetical replacement employee would be paid to perform the same services and duties, with the same skill level, education, and so forth.

U.S. Tax Courts

The U.S. tax courts have identified many factors as being meaningful in the determination of the level of reasonable compensation that can be useful as applied in determinations made within professional practices. In Pulsar Components, Inc., v. Commissioner (T.C. Memo 1996-129), the Tax Court set forth an extensive list of the factors to consider in a reasonable compensation analysis. The factors articulated in this case are:

• The employee's qualifications;
• The nature, extent, and scope of the employee's work;
• The size and complexities of the employer's business;
• A comparison of salaries paid with the employer's gross and net income;
• The prevailing general economic conditions;
• A comparison of salaries with distributions to officers and retained earnings;
• The prevailing rates of compensation for comparable positions in comparable concerns;
• The salary policy of the employer as to all employees;
• The amount of compensation paid to the particular employee in previous years;
• The employer's financial condition;
• Whether the employer and employee deal at arm's length;
• Whether the employee guaranteed the employer's debt;
• Whether the employer offers pension or profit-sharing plans to its employees; and
• Whether the employee was reimbursed for expenses that the employee paid personally.

In Elliots, Inc. v Commissioner, 716 F, 2d, 1241, 1983, U.S. App., the Tax Court set forth an oft-cited standard to determine the reasonableness of compensation for owners of closely held corporations:

• The owners' qualifications and role in the corporation;
• The corporation's character and condition;
• Compensation levels for comparable positions in similar companies;
• The corporation's salary policy; and
• The Independent Investor Standard.

The Independent Investor Standard

The fifth criterion was a judicially created analysis that determined how a hypothetical third-party purchaser of the corporation would compensate the executive position at issue. This Independent Investor Standard has received a large amount of attention in other cases as a meaningful way to indirectly measure the propriety of owner-employee compensation through an analysis of the returns provided at the enterprise investor level. The concept here is that if an independent investor in the enterprise is considered to be receiving a satisfactory arms-length return on his or her investment, then the amounts being paid to the owner-employee(s) must be reasonable in relation to the remaining returns available at the investor level.

The Mad Auto Wrecking, Inc. v Commissioner decision indicated the factors that can be considered in determinations of reasonable compensation (See Mad Auto Wrecking, Inc. v. Commissioner, TC Memo, 1995-153, 69 TCM 2330, April 5, 1995). These include:

• The employee's qualifications;
• The nature, extent, and scope of the employee's work;
• The size and complexities of the employer's business;
• Comparison of salaries paid with the employer's gross and net income;
• The prevailing general economic conditions;
• A comparison of salaries with distributions to shareholders and retained earnings;
• The prevailing rates of compensation for comparable positions in comparable concerns;
• The salary policy of the employer as to all employees;
• The amount of compensation paid to the particular employee in previous years;
• The employer's financial condition;
• Whether the employer and employee dealt at arm's length;
• Whether the employee guaranteed the employer's debt;
• Whether the employer offered a pension plan or profit-sharing plan to its employees; and
• Whether the employee was reimbursed by the employer for business expenses that the employee paid personally.

The court indicated that, in analyzing the above factors, there must be convincing evidence that the purported compensation was paid for actual services rendered by the employees/shareholders, as opposed to being a distribution of earnings that the payer could not deduct. On the other hand, it is recognized that ambition, inventiveness and energy play a role in the success of the enterprise, and these attributes should also be rewarded. In this specific case, the court recognized that the subject employee/shareholder's contributions to the enterprise were “fundamental, substantial and all-encompassing.”

In In re Marriage of Ackerman (2006), Cal.App 4th, Dec. 27, 2006, the court made its own determination of reasonable compensation, considering factors including:

• The situation of the business premises;
• The amount of patronage;
• The personality of the parties engaged in the business;
• The length of time the business has been established; and
• The habit of its customers in continuing to patronize the business.

The court continued in its analysis to indicate it used a “commonsense view” by considering the evidence of the actual business situation, talent, training, expertise, and reputation.

While there are several other significant tax court cases that deal with reasonable compensation determinations, two are particularly noteworthy examples of instances where the Internal Revenue Service has lodged challenges. In Exacto Spring Corp. v CIR, 196 F.3d 833 (7th Circuit, 1999), seven factors were identified as relevant to determinations of reasonable compensation:

• Type and extent of the services provided by the business owner-employee;
• Scarcity of qualified replacement employees;
• Qualifications and prior earnings capacity of the employee;
• Contributions of the employee to the business venture;
• Net earnings of the employer;
• Prevailing compensation paid to employees with comparable jobs; and
• Peculiar characteristics of the employer's business.

In a similar challenge to the notion of reasonable compensation by the Internal Revenue Service, in LabelGraphics, Inc. v. CIR, 221 F.3d 1091 (9th Circuit, 2000), the following factors were considered:

• Employee's role in the company;
• Comparison of the business owner-employee's compensation with those paid by similar companies for similar services;
• Character and condition of the company;
• Potential conflicts of interest; and
• Evidence of an internal inconsistency in a company's treatment of payments to employees.

It is interesting to note the emphasis in these two cases on an evaluation of the company itself and its ability to find replacement services for the subject employee. This is particularly relevant to owner-employees who multi-task, providing an array of contributions to the enterprise, fulfilling a work schedule that provides a wide range of expertise and service, often with excess hours of service as compared with traditional employees, if sufficiently examined. That being said, it is also difficult in many instances to distinguish the subtle areas where an owner-employee often contributes to enterprise success, including mentoring others, marketing and business development, management and leadership, recruitment and training, discipline and performance evaluation, and strategic vision, just to indentify a few areas.

As noted above, under the Internal Revenue Code and related regulations, compensation is generally deductible when it is deemed to be ordinary, necessary, paid or incurred during the year for personal services rendered, and reasonable in amount. Professional practices, regardless of form of organization, primarily do one thing. They provide services that are largely the result of the personal services rendered by the professionals within the enterprise. It is logical to conclude that the net earnings of the professional practice represent the reasonable compensation to those professionals, after an allowance for other ordinary, necessary, and reasonable operating expenses, together with a reasonable return on the capital investment in the enterprise.

In the context of applying the guidance found from the above tax court cases to determinations of reasonable compensation in professional practices, such determinations should consider:

• Type of professional service(s) offered (some foster more repeat business than do others; some specialties foster more referrals than do others);
• Type of specialty(ies), if any;
• Location(s);
• Age and health of the professional;
• Nature and duration of the professional's practice, either as a sole proprietorship or as a member of a partnership or professional corporation;
• How fees are billed, i.e., institutional-based, government programs, client pay, etc.;
• Specific practitioner's hours worked and efficiency of production;
• Other management and administrative responsibilities of the practitioner;
• Economic and demographic conditions in the practice's market area(s); and
• Number of locations the practice utilizes.

Conclusion

This article is intended to provide some basic insights on the factors that need to be evaluated when reasonable compensation is at issue in a law firm setting. Our firm has been involved in a number of recent engagements to assist the owners of professional service firms to evaluate the appropriate criteria and weighting of same used to allocate profits between the ownership group. The factors outlined above can be helpful in the design and implementation of compensation systems, and in helping the individuals who are impacted by these systems to better understand the rationale for how enterprise level profits are to be shared.

A question that arises repeatedly in professional service firms is what constitutes reasonable compensation for employee-owners. For many firms, no single operating expense category impacts the bottom-line enterprise profit as much as the compensation paid to the employee-owners of the enterprise. Clearly, an expense that is discretionary to the owner in terms of its magnitude, timing and method of payment, may represent not only compensation for services rendered, but may also be a disguised dividend or a distribution of profits. The amount of profits paid as compensation determined to be “reasonable” for tax reporting purposes can easily be manipulated by adjusting the compensation paid within the ownership group.

This article is intended to provide some fundamental guidance for attorneys and law firms whenever employee-owner compensation is at issue. In many instances, this focus will relate to ownership decisions regarding the overall allocation and character of enterprise profits, but the same concepts and analytical framework can be of benefit in the assessment of reasonable compensation for other purposes, such as the valuation of a non-compete agreement and in the segregation and measurement of personal/professional versus enterprise goodwill for dissolution of marriage purposes in jurisdictions where this aspect is in play. (See Identifying and Measuring Personal Goodwill in a Professional Practice, by Mark O. Dietrich, CPA/ABV, AICPA CPA Expert, Spring 2005.) Another emerging area where these principles are often applied is in the evaluation of excess or inadequate compensation challenges by the Internal Revenue Service, with respect to closely held C corporations or Subchapter S corporations, respectively. The issue with S corporations paying too little in wages to the owners to allow them to take a larger share of enterprise profits as distributions not subject to employment taxes has received significant recent attention from the Internal Revenue Service on behalf of the Social Security administration. This article provides guidance on what factors would be considered in determinations of reasonable compensation for this purpose.

Employee-owners' Compensation

Employee-owners' compensation is also often evaluated closely for business valuation purposes because the overstatement of compensation for these individuals can lead to an understatement of the value of the business enterprise within the application of several commonly used valuation methodologies. In these instances, the ultimate opinion of enterprise value can turn on the ability to support compensation for the controlling owners or professional practitioners. The normalized expense that is deducted should represent the compensation that would be paid to the practitioner in an arm's-length arrangement for the duties and services performed.

Reasonable Compensation

The following general characteristics should be considered in addressing reasonable compensation determinations:

• Experience of the owner/practitioner;
• Hours worked on a daily or periodic basis;
• Responsibilities of the position;
• Primary and ancillary duties performed;
• The age of the owner/practitioner;
• Nature of the business/professional practice;
• Geographic setting of the business/professional practice;
• Demographic characteristics of the area served by the enterprise/professional practice; and
• Sustainable revenues of the practice.

The term “reasonable compensation” is actually derived from Section 162(a) of the Internal Revenue Code. Section 162(a) provides for a corporation to deduct as a business expense “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Although tax courts have frequently addressed the reasonable compensation issue, divorce courts have not routinely devoted as much attention. The application of these concepts to determinations of reasonable compensation generally should not be understated.

Often, the determination of reasonable compensation levels among practitioners is critical to the harmony and long-term success of the enterprise. At the same time, these decisions can be the most difficult to make. The goal is to set the respective salaries for each individual to an amount that is on par with what someone would be paid to perform the same services and duties, broadly defined, as the current manager/owner does. To determine a fair salary, one needs to determine what a hypothetical replacement employee would be paid to perform the same services and duties, with the same skill level, education, and so forth.

U.S. Tax Courts

The U.S. tax courts have identified many factors as being meaningful in the determination of the level of reasonable compensation that can be useful as applied in determinations made within professional practices. In Pulsar Components, Inc., v. Commissioner (T.C. Memo 1996-129), the Tax Court set forth an extensive list of the factors to consider in a reasonable compensation analysis. The factors articulated in this case are:

• The employee's qualifications;
• The nature, extent, and scope of the employee's work;
• The size and complexities of the employer's business;
• A comparison of salaries paid with the employer's gross and net income;
• The prevailing general economic conditions;
• A comparison of salaries with distributions to officers and retained earnings;
• The prevailing rates of compensation for comparable positions in comparable concerns;
• The salary policy of the employer as to all employees;
• The amount of compensation paid to the particular employee in previous years;
• The employer's financial condition;
• Whether the employer and employee deal at arm's length;
• Whether the employee guaranteed the employer's debt;
• Whether the employer offers pension or profit-sharing plans to its employees; and
• Whether the employee was reimbursed for expenses that the employee paid personally.

In Elliots, Inc. v Commissioner, 716 F, 2d, 1241, 1983, U.S. App., the Tax Court set forth an oft-cited standard to determine the reasonableness of compensation for owners of closely held corporations:

• The owners' qualifications and role in the corporation;
• The corporation's character and condition;
• Compensation levels for comparable positions in similar companies;
• The corporation's salary policy; and
• The Independent Investor Standard.

The Independent Investor Standard

The fifth criterion was a judicially created analysis that determined how a hypothetical third-party purchaser of the corporation would compensate the executive position at issue. This Independent Investor Standard has received a large amount of attention in other cases as a meaningful way to indirectly measure the propriety of owner-employee compensation through an analysis of the returns provided at the enterprise investor level. The concept here is that if an independent investor in the enterprise is considered to be receiving a satisfactory arms-length return on his or her investment, then the amounts being paid to the owner-employee(s) must be reasonable in relation to the remaining returns available at the investor level.

The Mad Auto Wrecking, Inc. v Commissioner decision indicated the factors that can be considered in determinations of reasonable compensation (See Mad Auto Wrecking, Inc. v. Commissioner, TC Memo, 1995-153, 69 TCM 2330, April 5, 1995). These include:

• The employee's qualifications;
• The nature, extent, and scope of the employee's work;
• The size and complexities of the employer's business;
• Comparison of salaries paid with the employer's gross and net income;
• The prevailing general economic conditions;
• A comparison of salaries with distributions to shareholders and retained earnings;
• The prevailing rates of compensation for comparable positions in comparable concerns;
• The salary policy of the employer as to all employees;
• The amount of compensation paid to the particular employee in previous years;
• The employer's financial condition;
• Whether the employer and employee dealt at arm's length;
• Whether the employee guaranteed the employer's debt;
• Whether the employer offered a pension plan or profit-sharing plan to its employees; and
• Whether the employee was reimbursed by the employer for business expenses that the employee paid personally.

The court indicated that, in analyzing the above factors, there must be convincing evidence that the purported compensation was paid for actual services rendered by the employees/shareholders, as opposed to being a distribution of earnings that the payer could not deduct. On the other hand, it is recognized that ambition, inventiveness and energy play a role in the success of the enterprise, and these attributes should also be rewarded. In this specific case, the court recognized that the subject employee/shareholder's contributions to the enterprise were “fundamental, substantial and all-encompassing.”

In In re Marriage of Ackerman (2006), Cal.App 4th, Dec. 27, 2006, the court made its own determination of reasonable compensation, considering factors including:

• The situation of the business premises;
• The amount of patronage;
• The personality of the parties engaged in the business;
• The length of time the business has been established; and
• The habit of its customers in continuing to patronize the business.

The court continued in its analysis to indicate it used a “commonsense view” by considering the evidence of the actual business situation, talent, training, expertise, and reputation.

While there are several other significant tax court cases that deal with reasonable compensation determinations, two are particularly noteworthy examples of instances where the Internal Revenue Service has lodged challenges. In Exacto Spring Corp. v CIR, 196 F.3d 833 (7th Circuit, 1999), seven factors were identified as relevant to determinations of reasonable compensation:

• Type and extent of the services provided by the business owner-employee;
• Scarcity of qualified replacement employees;
• Qualifications and prior earnings capacity of the employee;
• Contributions of the employee to the business venture;
• Net earnings of the employer;
• Prevailing compensation paid to employees with comparable jobs; and
• Peculiar characteristics of the employer's business.

In a similar challenge to the notion of reasonable compensation by the Internal Revenue Service, in LabelGraphics, Inc. v. CIR , 221 F.3d 1091 (9th Circuit, 2000), the following factors were considered:

• Employee's role in the company;
• Comparison of the business owner-employee's compensation with those paid by similar companies for similar services;
• Character and condition of the company;
• Potential conflicts of interest; and
• Evidence of an internal inconsistency in a company's treatment of payments to employees.

It is interesting to note the emphasis in these two cases on an evaluation of the company itself and its ability to find replacement services for the subject employee. This is particularly relevant to owner-employees who multi-task, providing an array of contributions to the enterprise, fulfilling a work schedule that provides a wide range of expertise and service, often with excess hours of service as compared with traditional employees, if sufficiently examined. That being said, it is also difficult in many instances to distinguish the subtle areas where an owner-employee often contributes to enterprise success, including mentoring others, marketing and business development, management and leadership, recruitment and training, discipline and performance evaluation, and strategic vision, just to indentify a few areas.

As noted above, under the Internal Revenue Code and related regulations, compensation is generally deductible when it is deemed to be ordinary, necessary, paid or incurred during the year for personal services rendered, and reasonable in amount. Professional practices, regardless of form of organization, primarily do one thing. They provide services that are largely the result of the personal services rendered by the professionals within the enterprise. It is logical to conclude that the net earnings of the professional practice represent the reasonable compensation to those professionals, after an allowance for other ordinary, necessary, and reasonable operating expenses, together with a reasonable return on the capital investment in the enterprise.

In the context of applying the guidance found from the above tax court cases to determinations of reasonable compensation in professional practices, such determinations should consider:

• Type of professional service(s) offered (some foster more repeat business than do others; some specialties foster more referrals than do others);
• Type of specialty(ies), if any;
• Location(s);
• Age and health of the professional;
• Nature and duration of the professional's practice, either as a sole proprietorship or as a member of a partnership or professional corporation;
• How fees are billed, i.e., institutional-based, government programs, client pay, etc.;
• Specific practitioner's hours worked and efficiency of production;
• Other management and administrative responsibilities of the practitioner;
• Economic and demographic conditions in the practice's market area(s); and
• Number of locations the practice utilizes.

Conclusion

This article is intended to provide some basic insights on the factors that need to be evaluated when reasonable compensation is at issue in a law firm setting. Our firm has been involved in a number of recent engagements to assist the owners of professional service firms to evaluate the appropriate criteria and weighting of same used to allocate profits between the ownership group. The factors outlined above can be helpful in the design and implementation of compensation systems, and in helping the individuals who are impacted by these systems to better understand the rationale for how enterprise level profits are to be shared.