Tax Memo

For Colour Wheel Corporation, the other side of the spectrum is the managerial power model, which is based on the assumption that primarily because of structural bias, directors do not bargain at arm's length with managers." As a result, the model suggests that executive compensation structures are more generous and less performance-sensitive than those that would be the product of arm's length bargaining. The structural bias results primarily from the fact that directors are often, as a de facto matter, appointed by management." In addition, because management and directors work closely together and often run in the same social circles, it is argued that directors do not negotiate as hard as they would with truly adverse parties."

A similar tax avoidance strategy is sometimes used by closely held corporations where the principal shareholders are also the principal employees. If the shareholders/employees take cash out of the company through payment of dividends, the corporation gets no deduction for the dividends." On the other hand, if the shareholders/employees take cash out of the company through payment of salaries and bonuses, the corporation is allowed a deduction for the compensation payments (provided that the corporation's characterizations of the payments are " Recognizing this, the IRS attempts to protect the tax base by ensuring that purported salary payments to shareholder/employees are not in substance disguised dividends which relies on the reasonableness factor to do the heavy lifting in this regard. A critical factor in the reasonableness analysis in the corporate context is therefore the degree of overlap between the employees and the shareholders" (IRS, 2012).

If the corporation has four 25% shareholders who each perform similar services for the corporation, the risk of disguised dividends is very high. If, on the other hand, only one of the four shareholders is an employee of the corporation, ...