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Tax Law

Profits or Salary? New Jersey Tax Court Determines Distributions Are Dividends, Not Compensation for Services

The New Jersey Tax Court held that distributions made to a corporation’s two shareholders constituted dividends, and rejected the corporation’s argument that the distributions should be treated as compensation for managerial services that could be deducted for New Jersey Corporation Business Tax purposes. The Court explained that New Jersey has adopted the federal test to determine whether a distribution constitutes compensation for services rendered, which provides that: (1) the amount of the compensation must be reasonable, and (2) the payments must, in fact, be purely for services. The Court explained that proof of the second prong can be difficult to establish, so courts generally concentrate on the first prong. To determine whether compensation is reasonable under the first prong, courts consider: (1) the employee’s role in the corporation; (2) a comparison of the compensation payment with those paid by similar companies for similar services; (3) the size and complexity of the company’s business; (4) the existence of a relationship between the company and its employee which would permit disguising of nondeductible dividends as salary, and (5) whether internal consistency exists in the corporation’s treatment of payments to employees. Having analyzed the factors, the Court determined that there was no evidence in the record establishing that it would be reasonable for the shareholders to receive the distributed amounts as compensation for services, and concluded that a reasonable independent shareholder would view the distributions as dividend payments.

Shore Bldg. Contractors, Inc. v. Dir., Div. of Taxation, No. 002027-2012 (N.J. Tax Ct. Oct. 3, 2019).