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Determining Reasonable Compensation
These 2 tests seem vague and broad, but they provide an approach to determining reasonable compensation.
"...reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances."
– IRS Regulation 1.162-7(b)(3)
In essence, reasonable pay falls within the range of competitive norms.
The context of reasonable compensation changes considerably with the business-type (formation) that the company uses.
Depending upon the business type, shareholder-employees may be considered company employees. If the owner can be classified as an employee, they may receive wages, benefits, and access to a retirement plan. These costs are deductible by the company.
Deciding how to balance compensation and profit distributions to owners is a major tax planning decision for closely held companies.
These reasonable compensation tests are also extended to some tax-exempt organizations. We discuss this issue in-depth in DLC Course 18: Intermediate Sanctions.
Memory Jogger
The type of business and deductible costs are important because: