For California corporate income tax purposes, a gas station and convenience store operator (corporation) was properly disallowed business expense deductions for officer compensation paid to its owners because the compensation constituted distributions of earnings. In this matter, the corporation was owned by a California-based married couple who each had a 50% stake in the corporation. The corporation sold its assets to a third party and, from the consideration, paid a sum to each of the owners. The corporation then deducted these amounts as officer compensation on its 2012 and 2013 corporate franchise tax returns, and the owners reported these amounts as taxable W-2 wages on their personal income tax returns. The Franchise Tax Board (FTB) found that the officer compensation to the owners constituted taxable distributions of earnings, not deductible compensation, and accordingly issued an assessment. Further, the FTB determined that the owners were liable for an accuracy-related penalty because they substantially understated the tax liability by failing to report the capital gain on the liquidating distributions from the corporation on their joint 2013 personal income tax return.
Generally, when payments are made to an individual who is both a corporate employee and a principal shareholder, a two-prong test is applied to determine (1) whether the payment is in fact made for services rendered (the intent prong) and (2) whether the amount of the payment is reasonable in relation to the services performed (the amount prong).
Here, the Office of Tax Appeals (OTA) noted that the officer compensation was paid to the owners primarily for tax savings purposes, and not as compensation for services rendered, because each of the owners received the same amount of compensation for both years in proportion to their ownership interest in the corporation. Since a direct proportional relationship between stock ownership and compensation is considered a very strong indication of a disguised dividend, the FTB properly denied business expense deductions for officer compensation. Finally, the owners were not entitled to an abatement of accuracy-related penalty because they failed to show reasonable cause for their tax understatement. Kriton Corporation, California Office of Tax Appeals, Nos. 20046093, 21037402, June 29, 2023, released September 2023