Reasonable compensation: still alive and kicking.

• Author: Moore, Philip E.

The reasonable compensation issue seems to be making a comeback. Although there have not been many cases over the past several years, recently, there have been more than a few. Several of these cases have espoused new criteria for determining if compensation paid to an executive is reasonable. The "independent investor test" involves considering whether an independent investor would approve the compensation package of an executive, given the return on his investment. A "return" involves several criteria, including dividends paid to shareholders and increases in the value of stock.

Normandie Metal Fabricators, Inc.

In Normandie Metal Fabricators, Inc., 5/30/01, aff'g TC Memo 2000-102, the Second Circuit affirmed the Tax Court's finding that compensation was not reasonable. This case points to the importance of documenting positions and criteria for determining compensation when paid. The Tax Court, applying the independent investor test, analyzed several criteria, including:

1. The employee's role in the company (e.g., position, hours, duties and special roles or duties);

2. Potential conflicts (i.e., ability to disguise dividends as salary--especially if there is one shareholder or a controlling shareholder, or when a large percentage of the compensation is a bonus);

3. Consistency in the compensation system;

4. Character and condition of the company (e.g., sales, net income, capital value and general economic fitness); and

5. Comparison with other companies (e.g., salaries paid to comparable employees in similar situations).

   The court discovered that Normandie paid the founding shareholder an unreasonable amount, despite the argument that his compensation was low in earlier years. The facts showed that the founding shareholder had significantly cut back his activity in the company and did not earn the compensation the company paid him. On the other hand, his son, the CEO, was now running the company and took significant bonuses, even in years when the company was average at best. An expert testified, on behalf of the IRS, that an independent investor would not be happy with the CEO's results and the Tax Court agreed.

   This case might have had a different outcome if Normandie had instituted a compensation plan with a formula containing specific measurable criteria with which it could determine remuneration. If the formula had been applied consistently from one year to the next, Normandie would have had a stronger position for claiming that the...