Reasonable Compensation, written by Anne E. Moran, Esq., of Steptoe & Johnson LLP, analyzes the issues relating to the deduction by an employer for a “reasonable allowance” under §162(a) for compensation generally paid to executives.  

The reasonable compensation issue most frequently arises in the context of closely held businesses, which often have an incentive for inflating owner/employee salaries in order to distribute profits as deductible compensation rather than nondeductible dividends.  

This Portfolio discusses in depth the multiple factors used by the IRS and the courts in determining reasonableness of compensation, the necessity for the actual performance of services, situations in which a deduction for reasonable compensation is not allowable, and other aspects of reasonable compensation. Various tax planning and controversy considerations also are discussed.  

This Portfolio analyzes the trend among the courts to use the “independent investor” standard as the primary indicator of reasonableness.  Reasonable Compensation also discusses the circumstances in which compensation is not deductible despite its reasonableness. The primary focus is on the standards for determining when employee compensation must be capitalized, including in-house compensation expenses paid in connection with an acquisition. 

The Worksheets include  sample clauses for use  in employment contracts, board resolutions, and by-laws. 

This Portfolio covers other important related topics such as §409A restrictions on deferred compensation, the Sarbanes-Oxley Act, third-party compensation, fringe benefits, and IRS audits of executive compensation. 

Reasonable Compensation allows you to benefit from:

• Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area
• Invaluable practice documents including tables, charts and lists
• Plain-English guidance from world-class experts
• Real-world and in-depth analysis that lets you explore various options
• Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more
• Alternative approaches to both common and unique tax scenarios 

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which cover every federal tax topic with expert, in-depth analysis, and offer commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

Detailed Analysis

I. Introduction

A. Scope

B. Origin and Purpose of the Statute

II. Determining Reasonableness Under the Regulations

A. In General

B. The Intent Test

1. In General

2. Initial Characterization as Noncompensation

3. Compensatory Form of Payment Does Not Comport with its Substance

C. The Amount Test

1. In General

2. Contingent Compensation Arrangements

3. Fixing the Amount

D. Characterization of Excessive Compensation

III. Judicially Developed Factors to Measure Intent and Amount

A. In General

B. Measuring Intent

1. Salary History of Individual

2. Dividend History

3. Formality and Timing of Corporate Action

4. Arm's Length Bargaining

C. Measuring Amount

1. Qualifications of the Employee

2. Contribution to Success of Business

3. Salary Scale for Other Employees

4. Salary Scale for the Industry

5. Independent Investor Standard

IV. Necessity for the Actual Performance of Services

A. In General

B. Amount and Nature of Services

C. Compensation in Respect of Prior Services

D. Compensation for Future Services

E. Assignment of Compensation

F. Compensation for Services on Behalf of a Related Taxpayer

G. Employee Acting in Multiple Capacities

H. Situations Not Involving Direct Performance of Services

1. Payments to Persons in Military Service

2. Bonuses to Professional Athletes

V. Situations Where Reasonable Compensation Is Not Deductible

A. In General

B. Compensation as a Capital Expenditure

1. The Interrelationship of § § 162 and 263

a. Origin-of-the-Claim Standard

b. Separate and Distinct Asset Standard

c. Nonincidental Future Benefit Standard

2. Interrelationship of Standards Post-INDOPCO

3. Third-Party Compensation

4. Capitalization of In-House Compensation Expenses in Connection with an Acquisition

a. Employee Compensation

b. Severance and Other Nonsalary Compensation

C. Compensation Violative of Public Policy

VI. Other Aspects of Reasonable Compensation

A. In General

B. Payment in Stock or Property

C. Fringe Benefits

1. In General

2. Stock Options and Employee Purchase Plans; Restricted Property

3. Pension and Profit-Sharing Plans

4. Insurance Plans

5. Meals and Lodging

D. Sarbanes-Oxley Act

1. In General

2. Escrow of Extraordinary Payments

E. Section 409A Restrictions on Deferred Compensation

1. Background and Scope

2. Restrictions and Limitations Imposed by § 409A

3. Special Rules

VII. Handling a Reasonable Compensation Case

A. At Administrative Levels

B. In Court

C. IRS Audits of Executive Compensation

VIII. Tax Planning

A. In General

B. Avoiding the Indicia of Unreasonableness

C. Relationship to Accumulated Earnings Tax Problems

D. The Effect of Reimbursement Arrangements

E. Subchapter S Corporations

F. Supplemental Withholding for Compensation Exceeding $1 Million

IX. $1 Million Limit on Deductible Compensation for Certain Key Executives of Publicly Held Corporations

A. In General

B. Excluded Compensation

1. Performance-Based Compensation

a. Stock-Based Compensation

b. Shareholder Approval

2. Contracts in Effect as of February 17, 1993

C. Regulations

X. Executive Compensation Under the Emergency Economic Stabilization Act of 2008

A. In General

B. Special Deduction Limitation

C. Covered Employees

Working Papers

Table of Worksheets

Worksheet 1 Internal Revenue Manual 4.35.2.5.2.2 Officer's Salaries

Worksheet 2 Sample Clauses for Employment Contracts, Board Resolutions, and By-Laws Requiring Reimbursement by Employee of Any Compensation Determined To Be Unreasonable

Bibliography

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