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general problem [in] * * * distinguishing between
dividends and compensation for services received by a
shareholder-employee of a closely held corporation.
What makes this situation troublesome is that the
shareholder-employee and the corporation are not
dealing with each other at arm’s length. It is likely
to be in the interests of both the corporation and the
shareholder-employee to characterize any payments to
the shareholder-employee as compensation rather than
dividends. For this reason, a taxpayer’s
characterization of such payments may warrant close
scrutiny to ensure that a portion of the purported
compensation payments is not a disguised dividend. See
Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361
(9th Cir. 1974).
In that regard, respondent points out that petitioner paid
out 26.7 percent and 57.1 percent of its gross income as
compensation for 1995 and 1996, respectively. In addition,
petitioner paid out in compensation to the Valentes’ 81.6 percent
and 88.7 percent of its taxable income before considering the
compensation deduction for 1995 and 1996, respectively.
E. The Internal Consistency in the Company’s Treatment of
Payments to Employees
Under this test, a company’s formal compensation program is
considered, and a comparative analysis is made of compensation to
shareholder/employees in relation to compensation of
nonshareholder employees. Petitioner had no such formal program;
instead, Mr. Valente would decide the amount of compensation on a
year-by-year basis. Moreover, the only other employee of
petitioner was a bookkeeper who did not have comparable
qualifications, responsibilities, etc.
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