Clarifying the Contours of “Reasonable Compensation”
The law has always favored the term “reasonable.” For example, the law affords protection against a negligence lawsuit if a person can demonstrate he or she acted as a reasonable person would have under similar circumstances. Moreover, federal tax law provides that a taxpayer may generally avoid federal tax penalties if the taxpayer had “reasonable cause” for a failure to comply with the Internal Revenue Code (the “Code”).
But, what is “reasonable”? For those who prefer bright-line rules, you will not like the answer. What is reasonable is often in the eye of the beholder, i.e., the decision maker. Stated differently, what is reasonable is difficult to ascertain in many cases because what is reasonable to one person may not necessarily be reasonable to another.
Given these ambiguities, it is no surprise that taxpayers and the IRS have historically quibbled over a corporation’s “reasonable allowance” for salary and other compensation. Because of the nature of subchapter C of the Code (applicable to C corporations), there is almost always a natural incentive to reduce the dual level of taxes at the corporate and individual level through paying higher compensation. However, in many instances, corporations also legitimately want to pay their employees, particularly hard-to-replace executives, competitive salaries and bonuses for hard work. This Insight discusses the reasonableness requirement for deduction of compensation under Section 162(a)(1) of the Code.
Under Section 162(a), a corporation may claim “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Thus, this provision permits corporations to claim a litany of business deductions such as rent, utilities, and the like, provided the expenses are, among other things, “ordinary” and “necessary.”
But Section 162(a)(1) adds an additional wrinkle or limitation to deductions claimed as compensation. Specifically, that provision provides a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The Regulations provide some additional color: compensation is reasonable for these purposes if the amount “would ordinarily be paid for like services by like enterprises under like circumstances.” See Treas. Reg. § 1.162-7(b)(3). In other words, reasonableness generally depends on what other similarly-situated corporations are paying similarly-situated employees.
Court Factors in Determining Reasonableness.
Federal courts have historically struggled to provide clarity on what constitutes reasonable compensation. This is because what is reasonable in one context may not be reasonable in another context. Nonetheless, in an attempt at some clarity, many courts have fashioned a multi-factor test, which looks at a host of factors to determine whether the compensation is reasonable. For example, the Fifth Circuit Court of Appeals reviews: (1) the employee’s qualifications; (2) the nature, extent, and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the company’s gross and net income; (5) the prevailing general economic conditions; (6) a comparison of salaries with distributions to stockholders; (7) the salary policy of the company as to all employees; and (8) the amount of compensation paid to the employee in previous years. See, e.g., Brewer Quality Homes, Inc. v. Comm’r, 122 Fed. App’x 88 (5th Cir. 2004); Owensby & Kritikos, Inc. v. Comm’r, 819 F.2d 1315 (5th Cir. 1987). No single factor is determinative. Rather, the Fifth Circuit considers and weighs the totality of the facts and circumstances to reach a decision. Owensby & Kritikos, Inc., 819 F.2d at 1323. Other federal courts have utilized some form or fashion of their own multi-factor test for reasonable compensation cases as well. See, e.g., Elliotts, Inc. v. Comm’r, 716 F.2d 1241 (9th Cir. 1983); Eberl’s Claim Serv., Inc. v. Comm’r, 249 F.3d 994, 999 (10th Cir. 2001); Dexsil Corp. v. Comm’r, 147 F.3d 96, 100 (2d Cir. 1998); Mayson Mfg. Co. v. Comm’r, 178 F.2d 115, 119 (6th Cir. 1949).
But not all federal courts have found the multi-factor test helpful—and perhaps rightfully so because under this test no single factor is determinative. For example, the Seventh Circuit Court of Appeals criticized the Tax Court’s utilization of a multi-factor test, stating:
In reaching its conclusion, the Tax Court applied a test that requires the consideration of seven factors, none entitled to any specified weight relative to another. The factors are, in the court’s words, ‘(1) the type and extent of services rendered; (2) the scarcity of qualified employees; (3) the qualifications and prior earning capacity of the employee; (4) the contributions of the employee to the business venture; (5) the net earnings of the employer; (6) the prevailing compensation paid to employees with comparable jobs; and (7) the peculiar characteristics of the employer’s business. It is apparent that this test, through it or variants of it (one of which has the astonishing total of 21 factors) . . . are encountered in many cases, leaves much to be desired—being, like many other multi-factor tests, ‘redundant, incomplete, and unclear.’
The Court concluded that the multi-factor test was, among other things, “nondirective” and invited “the Tax Court to set itself up as a superpersonnel department for closely held corporations, a role unsuitable for courts[.]” Rather than use anyversion of a multi-factor test, the Seventh Circuit opted instead to use the “independent investor test,” which evaluates the reasonableness of compensation payments from the perspective of a hypothetical independent investor, focusing on whether the investor would receive a reasonable return on equity after payment of the compensation at issue. See, e.g., H.W. Johnson, Inc. v. Comm’r, T.C. Memo. 2016-95.
Not surprisingly, courts have also struggled to apply the independent investor test consistently. As a general rule, however, they have found that rates of return on equity of at least 10% tend to indicate that an independent investor would be satisfied and thus payment of the compensation was reasonable. See id. In fact, some courts have found reasonable compensation at lower thresholds—for example, in Multi-Pak Corp. v. Comm’r, T.C. Memo. 2010-139, the Tax Court found a 2.9% rate of return reasonable. Conversely, federal courts have tended to strike down compensation as unreasonable under the independent investor test where the compensation results in returns on equity of zero or less than zero. See, e.g., H.W. Johnson, Inc. v. Comm’r, T.C. Memo. 2016-95, and cases cited therein. However, as with the multi-factor tests, the independent investor test has not always been used consistently or reliably by the federal courts.
Given the uncertainty in this area of federal tax law, the takeaway, at least to this practitioner, seems clear. First, C corporations should carefully try to document and support their compensation determinations for employees. If a particular employee is paid more than other similarly-situated employees of the company, the C corporation should attempt to document its support for a higher level of compensation. Second, if the compensation is questioned by the IRS at audit, C corporations should carefully explore whether the applicable multi-factor test and/or independent investor test provides support for their compensation determinations. In some cases, a well-reasoned expert report regarding the compensation may be helpful, although careful consideration must be given to the pros and cons of obtaining an expert report.
 Note however that this incentive has been somewhat reduced in recent years due to the Tax Cuts and Jobs Act’s reduction of corporate rates from 35% to 21%.