IRS Reasonable Executive Compensation

CRITERIA FOR REASONABLE COMPENSATION

The IRS has no authority to prevent a corporation from paying its executives whatever it likes. But the IRS can tell a corporation how much of the salary it finds reasonable for the purpose of deducting it as a business expense.

When a corporation's executive pay is questioned in tax court, different factors have been used to determine the reasonableness of the compensation.

Measuring "Reasonable Pay"

Here are 12 factors that judges have cited in their decisions on the deductibility of executive compensation:

• Qualifications. Education and experience in the field.
• Nature and scope of work.
• Size and complexity of business.
• Salaries vs. net income, sales, capital value. Though salaries might equal a large percentage of profit, these can be "catch-up payments" for lean years.
• Economic conditions. Despite difficult conditions, founder's skill may prove critical to above average business results.
• Salaries vs. payments to stockholders. Failure to pay dividends can be a "red flag," suggesting that some of a shareholder-employee's salary is a dividend disguised as tax-deductible salary. But failure to pay dividends also can result from a sharp increase in retained earnings.
• Salary policy. A long-standing, consistently applied compensation plan is evidence that compensation is reasonable.
• Financial condition. Corporation grew, becoming/remaining "very profitable" while the officers at issue were at the helm.
• Comparable pay. Expert witnesses can compare pay at other firms.
• Previous years' pay. A corporation can deduct compensation in one year even though the employee performed the services in a prior year, having deferred compensation "to build its business."
• Arm's-length dealings. When an employee controls a corporation, courts "closely scrutinize" that employee's pay, asking: "Would an independent investor have approved the pay?"
• Guaranteed debt. The fact that executives have personally guaranteed their company's debts is a plus.

Let's expand on the financial condition factor. A number of court cases have allowed a large increase in compensation to a stockholder-employee when the company becomes successful.

Determining reasonable compensation is extremely judgmental. Fortunately, there's considerable latitude allowed in setting compensation.