“C” Corp Reasonable Compensation

A recent case (TC Memo 2013-10) upheld the taxpayer’s deduction of compensation to its officer as reasonable.  The taxpayer (a privately-held nursing care business) was able to prevail because the owners did their homework and documented how they arrived at the officer compensation and corroborated its conclusion with third party experts in the compensation area.

IRC 162(a)(1) specifies two tests that must be met for compensation to be deductible – the compensation must be reasonable, and it must be paid purely for personal services actually rendered.  It is the first prong of this test that the IRS and courts focus most on.  Looking back to various cases, the Court identified six factors in determining the reasonableness of compensation:

The employee’s role in the business

• What is the employee’s position, hours worked, and duties performed?
• What is the significance of the employee to the business?
• How does the employee contribute to the success of the company?

Comparison of the employee’s salary with what similar companies pay for similar services

• What is the total compensation package given to the employee?
• How does this compare to what employees in similar-sized companies in a similar line of business pay for similar services?

The character and condition of the company

• What is the company’s size, profitability, and general economic health?
• Does paying the compensation amount compromise the company’s health beyond what an independent investor would allow?
• Is there an element of catch-up compensation paid, to account for years in which lower than customary compensation was paid to the employee?

Any potential conflicts of interest

• What is the relationship between the employee and the company?
• Could any of the compensation be, in fact, disguised dividends?

Internal consistency

• Is compensation set in a consistent manner year to year?
• Were bonuses awarded under a structured and formal program consistently applied?

Whether an independent investor would be willing to compensate the employee for that amount

• Does the compensation amount effectively deny a theoretical independent investor’s return on equity?
• Does the compensation amount compromise the ability of the company to grow or deplete the company assets?
• Is the compensation arrived at to basically siphon the profits out of the company?

It is often tempting for the owners of closely-held businesses to use compensation as the be-all and end-all in reducing profits in conjunction with year-end tax planning.  However, this must be done with care and deliberation, to ensure that the compensation paid adequately addresses the six criteria described above, in order to meet the reasonableness test.  Otherwise, what the IRS deems to be excess compensation is not deductible and may be taxed as a dividend to the recipient.

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