Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 79-8

1979-1 C.B. 92

Section 162
Section 316

IRS Headnote

Business expenses; closely held corporation; compensation to shareholder-employees. Deductions for reasonable compensation paid to shareholder-employees of a closely held corporation will not be denied on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock.

Full Text

Rev. Rul. 79-8

ISSUE

Will deductions under section 162(a) of the Internal Revenue Code of 1954 be disallowed to a closely held corporation for reasonable compensation paid to its shareholder-employees on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock?

LAW AND ANALYSIS

In Charles McCandless Tile Service v. United States, 422 F.2d 1336 (Ct. Cl. 1970), the United States Court of Claims found that the compensation paid by a closely held corporation with a poor dividend history to its two shareholder officers was within the realm of reasonableness, but the court nevertheless concluded, after an examination of the entire record, that a portion of the purported compensation was not in fact paid for services rendered and was therefore in reality a dividend distribution. The court cited among other authorities, Northlich, Stolley, Inc. v. United States, 368 F.2d 272 (Ct. Cl. 1966), in which many factors were employed to decide whether certain payments were reasonable compensation or disguised dividends.

As support for its holding that the purported compensation "necessarily" contained a distribution of corporate earnings, the Court of Claims cited among other authorities, Botany Worsted Mills v. United States, 278 U.S. 282 (1929), Ct. D. 39, VIII-1 C.B. 279 (1929), aff'g 63 Ct. Cl. 405 (1927), in which the Supreme Court of the United States concluded, after examining several factors including the corporation's dividend history and the compensation practice of other corporations in the same industry as the taxpayer, that certain payments to the stockholders were in fact disguised dividends. The citation to these cases in McCandless indicates that the court considered the taxpayer's dividend history as a factor that merited great weight but that was not by itself determinative.

In decisions rendered subsequent to McCandless, the United States Tax Court has repudiated any automatic dividend rule based solely on a poor dividend history by stating that "[w]hile the absence of dividends may indicate the presence of disguised dividends, it does not convert compensation determined to be reasonable into dividends." Davis & Sons, Inc. v. Commissioner, T.C. Memo 1975-229. In another opinion the court has held that, although the absence of a dividend history is "significant," other factors may be important. Nor-Cal Adjusters v. Commissioner, T.C. Memo 1971-200, aff'd, 503 F.2d 359 (9th Cir. 1974).

Two federal appellate courts that considered this issue declined to adopt an automatic dividend rule. The United States Court of Appeals for the Eighth Circuit has stated that "an absence of profits paid back to the shareholders as dividends justifies an inference that some of the purported compensation really represents a distribution of profits." Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 153 (8th Cir. 1974), cert. denied, 420 U.S. 908 (1975). The court in Schneider attached great weight to the taxpayer's dividend history but did not do so to create a conclusive presumption of a dividend distribution. Instead, the court utilized several factors--including "[a] most significant factor," namely, a comparison of the alleged compensation under consideration and the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry.

In Edwin's, Inc. v. United States, 501 F.2d 675 (7th Cir. 1974), the Seventh Circuit went beyond Schneider and repudiated any automatic dividend rule. In a factual situation nearly identical to McCandless, the court in Edwin's held that while the absence of a dividend history and the fact that workers employed in comparable positions with other companies were paid less than taxpayer were relevant, this evidence did not justify a conclusive presumption of nondeductibility. The court stated that "[w]hile the absence of dividends might be a red flag, it should not deprive compensation demonstrated to be reasonable under all of the circumstances of the status of reasonableness."

HOLDING

The failure of a closely held corporation to pay more than an insubstantial portion of its earnings as dividends on its stock is a very significant factor to be taken into account in determining the deductibility of compensation paid by the corporation to its shareholder-employees. Conversely, where after an examination of all of the facts and circumstances (including the corporation's dividend history) compensation paid to shareholder-employees is found to be reasonable in amount and paid for services rendered, deductions for such compensation under section 162(a) of the Code will not be denied on the sole ground that the corporation has not paid more than an insubstantial portion of its earnings as dividends on its outstanding stock.