Reasonable Compensation, Defining What it Means

The following is information concerning the standards that the IRS uses in determining whether an employee's compensation is “reasonable,” and hence deductible as a business expense, and the tax consequences that will occur if it is not.

Federal tax law generally allows an employer to deduct all the ordinary and necessary expenses incurred in carrying on its trade or business. This includes a reasonable allowance for salaries and other compensation for personal services actually rendered by employees and independent contractors.

An employer, however, cannot deduct an amount paid in the form of compensation if it is not in fact related to the purchase of services. If an employer is a corporation, and an excessive amount of “compensation” is paid to a shareholder-employee, the excess amount over what is considered reasonable compensation may be re-characterized as a dividend, provided there are adequate corporate earnings and profits to sustain this treatment. This can yield unfavorable tax consequences because dividends are not deductible by a corporation (and may be ordinary income to the recipient). In addition, a publicly held corporation generally may not deduct compensation paid to certain key executives in excess of $1 million per year, subject to exceptions. In determining whether compensation exceeds the $1 million limit, payments to a tax-qualified retirement plan (including salary reduction contributions) and amounts that are excludible from the executive's gross income (such as employer-provided health benefits and miscellaneous fringe benefits) are not taken into consideration.

If a corporate employer lacks earnings and profits, IRS re-characterization of compensation as a distribution “in respect of stock” (i.e., one that is made by virtue of an individual's stock ownership) does not produce dividend treatment. In that case, however, distributions in respect of stock are first applied to reduce a taxpayer's basis in his stock. After the basis is reduced to zero, any additional amounts are treated as a gain from the sale or exchange of property (i.e., as capital gains).

Even if compensation cannot be re-characterized as a distribution with respect to stock, however, “unreasonable” compensation can still cause adverse tax consequences. For instance, another possible re-characterization of excessive compensation is to treat the excess as, in part, payment for the transfer of property, if the employee has at some time transferred the employee's own property to the employer. The IRS may so re-characterize compensation when, for example, a partner sells his or her partnership interest to a corporation. This may result in part or all of an employee's compensation not being fully deductible in the current taxable year.

Whether compensation is reasonable depends on the facts and circumstances. In general, the IRS considers compensation to be reasonable if the amount involved would ordinarily be paid by a similar business for like services under similar circumstances to those that existed when the “contract” for services was entered into (i.e., when the employer and employee agreed on the employee's level of compensation).

It is the date of contracting for services, not the date when the payment is questioned by the IRS, that is used in determining whether compensation is reasonable. When compensation for a particular taxable year is questioned as excessive, a taxpayer can attempt to show that part of the amount paid in the current year is designed to reimburse the employee for services rendered in an earlier year for which the employee was not adequately compensated. A taxpayer can also attempt to show that compensation was reasonable by demonstrating that the employee made a special contribution to business development or in some other way contributed specially to the worth of the business, such as through the possession of highly specialized and valuable expertise.

In addition to an employee's regular salary, all other employer-provided benefits in exchange for services are considered in determining whether an employee's compensation is reasonable. This includes pension and welfare benefits as well as fringe benefits such as the use of a company car. Nevertheless, a relatively high salary may still be considered reasonable if the employee's other benefits are not more than would usually be provided a similar employee under like circumstances.

In general, the IRS is more likely to challenge an employee's compensation if the employer is a closely held business and the individuals receiving the compensation in question also own the business and control its operation, including the determination of how employees will be compensated. The rules, however, also apply to large businesses.

Because of the potential adverse tax consequences, taxpayers who receive large amounts of compensation in a taxable year should take steps to document the reasonableness of their compensation, which can then be produced in the event of an IRS audit. One key to defending successfully the reasonableness of compensation is to maintain contemporaneous records as to how compensation was determined and documenting the unique and valuable nature of the services to which the compensation relates. For instance, if an executive is given a special bonus, there should be a resolution or, if this is not feasible, a memorandum setting forth the details as to why the bonus was awarded. If the employer anticipates that a key executive will be earning less than would ordinarily be expected until a new business begins to be profitable and that the executive will be compensated with proportionately larger salary and benefits in future years, reference to this should be made in the executive's employment contract, if one exists, or otherwise documented in a resolution or memorandum.

I hope the foregoing has been helpful in answering your questions about reasonable compensation. If you have any questions about the matters discussed in this letter, please give us a call.