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Reasonable Compensation
In long-term compensation plans, there are four common themes:
- Provide a market competitive compensation plan to ensure the ability to attract, motivate, and retain key executives.
- Motivate and reward business leaders for long-term organizational success.
- Establish performance goals for executives that reflect the desired success.
- Provide tax effective compensation.
The last goal is constantly changing and requires complex and complicated application of tax laws. It is best to seek legal and tax counsel.
What is "reasonable compensation"? The IRS defines reasonable compensation as "the value that would ordinarily be paid for like services by like enterprises under like circumstances." Maximum reasonable compensation is a standard used by the IRS for the total compensation package, including bonuses and benefits.
Closely held corporations are the typical target of IRS reasonable compensation challenges. Although it depends on the type of corporation involved, some companies draw unreasonably low or unreasonably high compensation in order to minimize taxes. This has led the IRS to develop and define the concept of reasonable compensation. Tax regulations exist to examine unreasonable executive compensation for a:
- Stockholder who is an employee
- Person who owns all or most of the corporation's stock
- Other members of the primary stockholder's family
To learn how these analyses are made, see DLC Course 12: IRS Reasonable Executive Compensation.
Valuation
Maximum reasonable compensation would be the highest amount of the total compensation package, including salary, bonuses, and benefits, which would be an allowable IRS deductible business expense for services rendered by comparable employers.
What is considered "appropriate data"? As an example, for small organizations with gross receipts of less than $1 million, the compensation for similar positions paid by three comparable organizations is considered appropriate data. All other organizations must undertake a more detailed analysis of comparable compensation. It's also acceptable to obtain a compensation study from a qualified third party.
Payments under a compensation arrangement are presumed to be reasonable if the following conditions are satisfied:
- Arrangement is approved in advance by an authorized body
- The authorized body used appropriate comparability data
- The authorized body documented the basis for its determination