IRS Reasonable Executive Compensation

INTRODUCTION

What is reasonable compensation for executives?

Economists, psychologists, and politicians all have ideas about how and why executive compensation has gotten out of hand. A variety of laws and regulations have been proposed and enacted to deal with this perceived problem.

Regulations already exist in one area that deals with unreasonable executive compensation for a:

• shareholder-employee
• chief executive officer
• person who owns all or most of the corporation's stock
• other members of the primary shareholder's family

Although it depends on the type of corporation involved, there is often a motivation to draw unreasonably low or unreasonably high compensation in order to avoid taxation situations, as we will explain in this course. This has led the IRS to develop and define the concept of reasonable compensation.

Closely Held Companies

Closely held companies have a great deal of latitude in how to organize and allocate income and expenses. Such companies have only a limited number of shareholders whose stocks are usually privately traded, but there are some closely held publicly traded corporations (e.g., Mark Zuckerberg has a controlling interest in Facebook’s voting shares).

Public companies need to be organized as C corporations, but closely held companies can be:

• proprietorships
• partnerships
• limited liability companies
• S corporations
• C corporations

Q: How do you decide which business form to use?

A: The decision is often based on an attempt to draw out the MAXIMUM cash and benefits at the MINIMUM tax cost.

The stockholder-employee may do this as he or she desires, but the IRS will use a criterion of "reasonableness" to decide whether their decisions are allowable as expense deductions. The determination of reasonable compensation is the heart of this course.

Course Overview

This course will begin by examining what constitutes reasonable compensation.

We'll look at different ways companies are organized and how that impacts compensation and taxation.

Then we'll show you how to use research software to obtain average salary and maximum reasonable compensation data for a given shareholder-employee.

We'll also provide tips for setting compensation levels that will be perceived as reasonable. We'll look at the independent investor test, which considers the return on investment indicated by the increase in the value of a corporation's stock, along with dividends paid during a set time period.

Finally, we'll look at how a stockholder-employee's compensation affects business valuation, particularly in the cases of estate planning or the selling of a business.

Upon completion of this course, you should be prepared to advise on the proper setting of compensation levels that will prevent unreasonable compensation challenges from the IRS, board members, and shareholders.