IRS Reasonable Executive Compensation

THE CONCEPT OF REASONABLE COMPENSATION

Reasonable compensation is a relative term. What's appropriate depends on the circumstances in each case, as well as who is viewing the situation — in this case, the IRS.

The IRS looks at what similar companies are paying their executives.

The starting point for understanding the IRS concept of reasonable compensation is IRC 162(a). This section of the tax code allows companies to deduct the pay of employees for the services they perform as a business expense. The term pay may include wages, salaries, vacation allowances, bonuses, commissions, and benefits. In order to be deductible, these costs must meet 2 tests.

Test 1: Reasonable

The pay must be reasonable. It's the company's responsibility to prove that the pay is reasonable based on the particular circumstances that existed when the employee services were incurred.

The IRS considers the following factors in determining reasonable pay:

• the employee's duties and responsibilities
• training, experience, and achievements
• time and effort put into the business
• company dividend payment practices
• key employee bonus payment history
• policy regarding pay for all employees
• history of pay for each employee
• what comparable businesses pay for similar services

Note: These factors include those that are specific to the individual and those that are specific to the company as a whole.

These factors, like other lists of factors cited as indicative of either reasonable or unreasonable compensation, have evolved from case law. Congress has been content to allow the officially neutral Federal Tax Court to determine the meaning of IRS regulations. The operative factors regarding compensation deductibility continue to be derived from significant Tax Court decisions that are routinely cited. Researchers, IRS personnel, forensic experts, and even Tax Court judges themselves differ in the number of factors they cite; such variances typically stem from different definitions of the categories.

Reg. Sec1.162-7(b)(2) states that the form or method of fixing compensation is not decisive as to deductibility. Compensation that's determined on a contingency basis (e.g., 30% of gross revenue) is by nature suspect, but not necessarily unreasonable. The significant characteristic the IRS seeks is a direct negotiation between employer and employee.

Test 2: For Services Rendered

The pay must be for services rendered. Events that increase the value of the company but are unrelated to the executive's job or efforts are not justifiable reasons for unreasonable or excessive compensation.

This test is also important when family members or minority stockholders are involved.