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Reasonable Compensation (Portfolio 390)

Tax Management Portfolio, Reasonable Compensation, No. 390-5th, analyzes the issues relating to the deduction by an employer for a “reasonable allowance” under §162(a) for compensation paid with regard to personal services rendered. It discusses in depth the factors applied in determining reasonableness, the necessity for the actual performance of services, situations where a deduction for reasonable compensation is not allowable, and other aspects of reasonable compensation. Various tax planning and controversy considerations also are discussed.

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DESCRIPTION

Tax Management Portfolio, Reasonable Compensation, No. 390-5th, analyzes the issues relating to the deduction by an employer for a “reasonable allowance” under §162(a) for compensation paid with regard to personal services rendered. It discusses in depth the factors applied in determining reasonableness, the necessity for the actual performance of services, situations where a deduction for reasonable compensation is not allowable, and other aspects of reasonable compensation. Various tax planning and controversy considerations also are discussed.


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. The portfolio examines in detail the multiple factors used by the IRS and the courts in determining the reasonableness of compensation, and analyzes the trend toward using an “independent investor” standard as the primary indicator of reasonableness.


The portfolio also discusses the circumstances in which compensation is not deductible despite its reasonableness. These include the standards for determining when employee compensation must be capitalized, including in-house compensation expenses paid in connection with an acquisition, and statutory limitations on compensation under §162(m) of the Code.


The Worksheets include an excerpt from the Internal Revenue Manual instructing Revenue Agents on how to determine the reasonableness of officers' salaries and sample clauses that might be used in employment contracts, board resolutions, and by-laws to require employees to reimburse the employer for any compensation determined to be unreasonable.


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AUTHORS

ANNE E. MORAN
Anne E. Moran, Partner, Steptoe & Johnson, LLP; B.A., Wellesley College; J.D., Harvard Law School; formerly Tax Counsel, United States Senate Committee on Finance; former member of the ERISA Advisory Council for the United States Department of Labor; member, American Bar Association, Section of Taxation; member, American Bar Association, Joint Committee on Employee Benefits (former chair); member, District of Columbia Bar, Tax Section, Committee on Employee Benefits (former chair) and Steering Committee (former member); member, American College of Employee Benefits Counsel (former board member).

TABLE OF CONTENTS

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

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

OFFICIAL

Statutes:

Treasury Regulations:

Proposed Regulations:

Legislative History:

Treasury Rulings:

Notices and Releases:

Reports:

Cases:

UNOFFICIAL

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