Reasonable Compensation - Alive and Well?

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By Stuart M. Lewis, Esq.
Buchanan, Ingersoll & Rooney PC, Washington, DC

Section 162 of the Code provides a deduction for an employer's business expenses, including a deduction for reasonable compensation paid to employees. The term “reasonable compensation” has a long, inglorious history.

For many years, the IRS has, without great success, tried to impose limits on deductible compensation through the application of the reasonable compensation standard. Congress provided some help to the IRS with the enactment of the $1 million standard in §162(m) but the result of those limitations has had more to do with careful planning by tax advisors than with any substantial limitation on the deductibility of compensation.

2009 may well be the year of reasonable compensation limitations. Recent outrage by Congress and the public over bonuses paid to AIG employees and over “excessive” compensation in general, has produced a climate in which reasonable compensation limits may become meaningful. In fact, a senior member of the Senate Finance Committee has formally suggested to the IRS that it renew its efforts to impose limitations to the reasonable compensation standard on multi-million dollar salaries.

In addition, it currently appears that in the AIG aftermath Congress may well impose limitations on the deductibility of deferred compensation and could even go further by tightening the rules under §162(m) or providing other efforts designed to ensure that corporations cannot deduct the full amount of compensation, deferred or otherwise, in the case of executives with large salaries.

While clearly there is unjustified, astronomical compensation being paid to some executives, Congress should temper its current outrage with a more serious reflection on why corporations pay large amounts of compensation in the first place. In many cases, incentive compensation is fully justified by market forces and competitive pressures, factors which should be relevant in a capitalistic society. More to the point, it should be up to the owners of the business, i.e., the shareholders, whether compensation amounts paid to executives are justified or not. As long as adequate processes are in place to ensure that the business owners fully understand and agree with who can have compensation packages, it seems inappropriate for the IRS or Congress to develop more stringent standards.

For more information, in the Tax Management Portfolios, see Moran, 390 T.M., Reasonable Compensation, and in Tax Practice Series, see ¶5420, Reasonable Compensation.