Defining ‘Reasonable Compensation’ under the Tax Code

By  Linda Campbell, PhD, CPA, CGMAPamela C. Smith, PhD and Kasey Martin, PhD, CPA, CIA

October 2019 IssueFeatured |  October 2019

In Brief

Corporate tax deductions for executive compensation are a contentious topic, governed as they have been by the tax code’s nebulous use of the term “reasonable” to limit the amount that may be deducted. The authors provide an overview of the law and how it has been interpreted by the Treasury Department and the courts over the years. The Tax Cuts and Jobs Act took steps that should reduce such tax maneuvering, but its limited scope leaves much more to be done before full clarity and parity in executive compensation would be possible.

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Tax deductions for executive compensation have been an area of contention for almost a century among policymakers, corporate America, and concerned investors. Courts at nearly all levels have adopted different approaches to determine tax treatment, although the Supreme Court seems to have no interest in settling this controversy. Bright-line tests have been proposed for years, although none has ever been successfully adopted. Standardized, complex factors for determining compensation have been suggested but not widely implemented. While the concept has led to decades of accounting and tax posturing and endless court battles, it does not seem likely that the striking of the word “reasonable” from the phrase “reasonable compensation” or the setting of easy-to-calculate compensation limitations for all forms of ownership structure will ever occur.

The Tax Cuts and Jobs Act of 2017 (TCJA) took a giant step toward removing some of the corporate planning and tax maneuvering of compensation plans initialized by the 1994 enactment of Internal Revenue Code (IRC) section 162(m). Many “grandfathered” plans are, however, excluded from the two recent amendments, and nonpublic companies remain unaffected, leaving much more to be done before tax parity and clarity pertaining to executive compensation prevails. An overview of IRC section 162 and U.S. Treasury guidance and definitions, as well as a historic overview of legislative guidance and interpretation through the lens of forms of organization, may help managers and accounting professionals better understand the complex difficulty the IRS and the courts face when trying to achieve that seemingly elusive goal of taxpayer parity.

Legislative Grace

All tax deductions, including those for employee compensation, are a matter of legislative grace (New Colonial Ice Co. v. Helvering; Deputy v. du Pont; INDOPCO, Inc. v. Comm’r). The IRC specifically denotes the term “reasonableness” with respect to compensation for services. The term’s usage is widely accepted to infer a judgment call as to a question of fact, and the reasonableness requirement is in addition to the subjective standards to qualify as “ordinary and necessary.” Questions of judgment regarding reasonableness generally develop when dealing with closely held corporations; however, business entities of all legal forms can encounter problems of interpretation when it comes to deductibility of what the taxpayer believes is legitimate compensation [IRC section 162(a)(1) and Comm’r v. Lincoln Electric Co.].

Unchanged by the enactment of the TCJA, IRC section 162(a) permits deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” In general, to be deductible as an expense of a trade or business, compensation payments must be—

  • ordinary and necessary,
  • an expense of the payor’s trade or business during the taxable year,
  • reasonable in amount, and
  • for personal services actually rendered [IRC section 162(a) and (a)(1)].

IRC section 162 does not require that all business expenses be reasonable in amount, only compensation; however, the courts have held that an expense must not only be ordinary and necessary in order to be deductible, but that it must also be reasonable in amount and in relation to its purpose. In 2003, the Tax Court established a two-prong test for compensation deductions:

Section 162(a)(1) establishes a two-pronged test for the deductibility of amounts purportedly paid as salaries of other compensation for personal services actually rendered (without distinction, compensation for services): the payments must be (1) “reasonable”, and (2) “in fact payments purely for services” (E.J. Harrison & Sons, Inc. v. Comm’r).

In addition, if compensation is paid partly for business purposes and partly for nonbusiness or personal purposes, only the compensation applicable to the business purposes is deductible. More specifically, per IRC section 3231(e)(1), compensation is defined as “any form of money remuneration paid to an individual for services rendered as an employee to one or more employers.” The term does not include any payments to an employee (or dependent) on account of sickness or disability, tips, or any payments for traveling.

The second requirement for deductible compensation—“reasonable in amount”—is the most discussed aspect of deductibility. The courts have consistently determined that “reasonable” compensation is a question of fact (RTS Investment Corporation v. Comm’r; Estate of Wallace v. Comm’r; Kennedy, Jr. v. Comm’r; Charles Schneider & Co., Inc. v. Comm’r). In Kennedy v. Comm’r, the Tax Court stated, “Discerning the intent behind the compensation presents a question of fact, to be determined from all the facts and circumstances of the particular case.” Furthermore, in the same case, it held that “reasonableness of the compensation amount also presents a factual question to be resolved within the bounds of the individual case.”

Each argument for or against the reasonableness of compensation must stand on its own merits. In Miller Manufacturing Co. v. Comm’r, the Fourth Circuit Court noted:

It is well settled that the question of what constitutes, for the tax deduction here in issue, reasonable compensation to a specific officer of a corporation, is essentially a question of fact, to be determined by the peculiar facts and circumstances in each particular case.

The contested subject of reasonableness of compensation is one of the most frequently debated issues between business taxpayers and the IRS.

Interpretation over Time

Flourishing in court arguments for well over 90 years, the contested subject of reasonableness of compensation is one of the most frequently debated issues between business taxpayers and the IRS (see Rogers v. Hill, one of several compensation cases on record nearly a century old). Case law is extensive; however, no straightforward approach to determining reasonableness has ever been established. Because no discerning factor prevails, the courts often focus on various ideas and concepts for what is reasonable, with certain factors appearing to be more prevalent in legislative discussions. These factors include, but are not limited to, the employer’s form of organization, bonuses and disguised dividends, the ability of the employee, and the scope of the employee’s responsibility and nature of the work.

Employer’s Form of Organization

Closely held corporations are often at the forefront of compensation deduction rulings. Charles Schneider & Co., Inc. v. Comm’r is one of the earliest cases highlighting the need for increased scrutiny of compensation in closely held corporations. In this case, the court noted, “Where the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm’s-length bargaining as required.” Here, the Eighth Circuit Court determined nine factors were relevant to assessing the reasonableness of employee compensation: 1) employee qualifications; 2) the nature, extent, and scope of the employee’s work; 3) the size and complexity of the business; 4) prevailing general economic conditions; 5) prevailing rates of compensation for comparable positions in comparable concerns; 6) the salary policy of the taxpayer as to all employees; 7) previous years’ compensation (in the case of small corporations with a limited number of officers); 8) comparison of salaries paid with the gross income and the net income; and 9) comparison of salaries with distributions to stockholders. Again, as established in prior judicial proceedings, no one factor dominates the decision for reasonable compensation.

Another test established by the courts to determine the reasonableness of compensation is the “independent investor test” developed in Elliotts, Inc. v. Comm’r. The Ninth Circuit Court stated:

A relevant inquiry is whether an inactive, independent investor would be willing to compensate the employee as he was compensated. The nature and quality of the services should be considered, as well as the effect of those services on the return the investor is seeing on his investment.

In evaluating the reasonableness of compensation paid to shareholder-employees, the court applied a five-factor test:

  • The employee’s role in the company
  • A comparison of compensation between the employee and other similarly situated employees in similar companies
  • The character and condition of the company
  • Whether a conflict of interest exists that would permit a disguised dividend
  • Whether the compensation was paid pursuant to a structured and applied program (LabelGraphics, Inc. v. Comm’r).

One unique case analyzing reasonable compensation for shareholder-employees is Miller & Sons Drywall, Inc. v. Comm’r. The Tax Court applied the Schneider nine-factor test through the lens of the independent investor test of Elliotts. This approach allowed the court to determine whether the compensation would hold up in an arm’s-length transaction and “whether a corporation’s shareholders received a fair return on their investment.”

Bonuses & Disguised Dividends

For compensation arrangements, “the question of reasonableness of amount of salaries is inextricably wed to the question of whether the salaries were paid purely for services” (Nor-Cal Adjusters v. Comm’r). An often-contentious issue of compensation packages is bonus payments to employee-shareholders. Revenue Ruling 61-127, which addressed the timing for bonus deductions, applies to an employer who is obligated to pay a 2% (but not more than 3%) bonus. The company is not able to ascertain the exact percentage until after the close of the tax year; this ambiguity in turn led to an ambiguous deduction. Revenue Ruling 61-127 asserts that the 2% bonus is accruable and deductible for the tax year to which it relates and is subject to the “reasonableness” test. Any portion of the bonus above the 2% that is paid in the following tax year is deductible in that tax year “to the extent that such bonuses constitute reasonable compensation for services rendered” (Nor-Cal Adjusters and Klamath Medical Service Bureau v. Comm’r).

Corporations often rely on comparing similarly situated executives of other companies when establishing reasonable compensation; the courts, however, have determined this is only one of many factors needed.

Closely held corporations may have incentives to disguise dividend distributions as compensation expense, as noted in Haffner’s Service Stations v. Comm’r. In Charles McCandless Tile Service v. U.S., the U.S. Court of Claims noted that “even a payment deemed reasonable, however, is not deductible to the extent that it is in reality a distribution of corporate earnings and not compensation for services rendered.” As numerous judicial proceedings have found, scrutiny of payments within closely held corporations is always warranted. In McCandless Tile Service, the company had neither declared nor paid any dividends since its inception; in the tax year in question, however, 50% of the net profits were paid as compensation. The court thus reasoned, “any return on equity is so conspicuous by its absence as to indicate, given all the facts, that the purported compensation payments necessarily contained a distribution of corporate earnings within.” As a result, part of the compensation payment was deemed a disguised dividend.

Nine years after McCandless Tile Service, the Treasury Department issued Revenue Ruling 79-8, addressing whether closely held corporations were allowed a compensation deduction to shareholder-employees when the corporation had not paid any substantive portion of its earnings as dividends. Relying upon the Supreme Court’s decision in Botany Worsted Mills v. U.S. that dividend history, or lack thereof, was a relevant factor in analyzing disguised dividends, the Treasury Department noted that history is a relevant factor but “not by itself determinative.”

The U.S. District Court of Colorado addressed whether bonus payments to a shareholder-owner were disguised dividends in Joseph P. Kropf, Inc. v. U.S. The court noted several relevant factors:

  • The bonus was an additional amount paid over the designated salary.
  • The bonus directly corresponded to the employee’s stock holdings.
  • The company had never declared a dividend, even though it realized earnings and profits.
  • The bonus was not fixed and was not determined before profits were known.
  • Bonuses were not paid in prior years because earnings were placed back into the business.

These factors led the district court to determine that the bonus was actually a distribution of current earnings and profits, and thus not deductible.

Ability of the Employee

Employee qualifications are another factor in determining whether compensation is reasonable. Corporations often rely on comparing similarly situated executives of other companies when establishing reasonable compensation; the courts, however, have determined this is only one of many factors needed. In Transport Manufacturing & Equipment Co. v. Comm’r, the Tax Court originally denied a deduction for compensation paid to Richard Riss, Jr., the 26-year-old president of the company. The Eighth Circuit Court noted:

In dispute is not the salary of simply the president of a corporation, but rather, the salary paid to Richard as president. The Tax Court properly considered Richard’s prior salaries in comparison, his lack of qualifications and executive experience, his virtually nonexistent authority, and the basis of his compensation computation.

Age is not a dominant factor for employee qualifications, but experience is. In Meyer Hecht (2 BTA 319), the owner’s 22-year-old son began working in the business and “devoted his entire time to the taxpayer’s business.” His compensation arrangement, however, called for a salary of 25% of net profits, which the court determined was excessive, considering other employees in the office were better qualified to handle the business.

Scope of Employee Responsibility

The heart of a reasonable compensation case is often a debate over an employee’s role and responsibilities at an organization. For example, the U.S. District Court (Nebraska) emphasized that the work performance of employees is crucial in determining reasonable compensation in Trucks, Inc. et al. v. U.S. Work performance factors included, but were not limited to, the position held, the hours worked, the duties performed, and the employee’s responsibility. The court further emphasized that each individual employee’s performance must be assessed separately. The Tax Court has noted that a high level of compensation may be justified based on an “employee’s superior qualifications,” and compensation may reflect the employee’s contribution to the business (Diverse Industries, Inc. v. Comm’r; see also Home Interiors & Gifts, Inc. v. Comm’r).

“Reasonable” is a matter of subjective decision making based on array of endless considerations. Nevertheless, it seems highly unlikely that the concept will ever be scrapped from the law.

More recently, in Midwest Eye Center, S.C. v. Comm’r, the petitioner was an ophthalmology surgery and care center with one physician serving as the president, CEO, medical director, CFO, and 100% shareholder. The IRS denied the deduction of a $1 million bonus to the physician on the basis it failed the “reasonable” test. The petitioner argued that the physician’s significantly increased workload, and his managerial duties as CEO, CFO, and COO, warranted the bonus; however, it failed to provide any methodology to illustrate how the bonus was determined with respect to his managerial duties. Despite the petitioner’s argument that the physician’s expertise and scope was significant, the IRS denied the deduction due to the lack of substantiation.

Problems with a Multifactor Test

As evidenced by the numerous judicial proceedings concerning “reasonable” compensation, multifactor tests of reasonableness are currently the standard; however, this can result in decisions that seem arbitrary and idiosyncratic. Although the validity of relying on multifactor tests has been questioned by the courts, the application of these tests dates back nearly a century. The courts have clearly determined that “reasonable” is based on the “facts and circumstances” and a bright-line test is not the most appropriate measure. Evolving industries and economic conditions seem to warrant a multifactor approach, but over the decades, this approach has often proven unruly and lacking in parity. Whether the business sells animal hides in 1925 (Meyer Hecht) or is a family-owned contracting business facing an IRS audit in early 2000 (Devine Brothers v. Comm’r), the legal premise for determining deductible (not “reasonable”) compensation should remain clear.

TCJA Changes

The newly amended IRC section 162(m) rules apply only to publicly traded companies for fiscal years beginning on or after January 1, 2018. A “covered employee” is any employee who has ever been the CEO, CFO, or one of the three highest compensated officers in any fiscal years beginning after December 31, 2016. Once covered, an employee is always covered, even after termination, and including payments to the individual’s beneficiaries following the individual’s death.

In addition to substantially increasing the number of covered executives and thereby increasing the amount of compensation that is likely to be nondeductible, Congress broadened the definition of publicly traded corporations. There is a transition rule allowing any payments in excess of $1 million to remain fully deductible if there was a binding contract in place prior to November 2, 2017.

A Wake-up Call for CPAs and Managers

Accounting and tax professionals will recall that IRC section 162(m) was passed based on public concern that executive compensation was excessively high and not suitably tied to corporate performance. Prior to the TCJA, corporations commonly chose to pay executive compensation that was nondeductible, representing an estimated $22 billion in lost tax savings from 1994 to 2016. During that time, mean total compensation levels increased significantly, exceeding both inflation and wage increases for the average American worker.

“Reasonable” is a matter of subjective decision making based on array of endless considerations. Nevertheless, it seems highly unlikely that the concept will ever be scrapped from the law. In the end, it may be the TCJA’s lower corporate tax rates and qualified business income (QBI) deduction for pass-through entities that come to govern the amounts that businesses attempt to substantiate in the future, making the concept of “reasonable” generally irrelevant to the overall compensation picture.

CPAs and managers should still be looking ahead, as planning opportunities still exist under the TCJA. The following steps can help reveal those opportunities:

  • Develop and consistently maintain a listing of all “covered” employees
  • Be vigilant by not inadvertently creating a “covered” employee
  • Seek additional tax and legal advice before modifying preexisting compensation plans
  • Keep abreast of upcoming changes, as IRS guidance is not set on this issue.

Will there be future calls for Congress to expand the $1 million deduction limitation to all of a company’s employees? Is there a possible place for no-decision-path methods (similar to the two-method decision tree used to calculate deductible QBI for pass-through entities under the TCJA)? Will the next generation of policymakers view Tax Court battles over this issue as never ending and ineffective?

The authors can scarcely envision a future where the reasonableness of deductible compensation is governed by the open market, as is any other “ordinary and necessary” business expense. Nevertheless, it is hard not to wish for a simpler solution than what exists under pres ent law.