Taxing unreasonable compensation: (section) 162(a) (1) and managerial power.

• Author: Zelinsky, Aaron S.J.

In March 2009, the American International Group provoked a firestorm by releasing compensation data for executives in the company's failed derivatives trading group. (1) These bonuses were quickly derided as "most outrageous" and "unreasonable." (2) The House of Representatives subsequently passed legislation attempting to recoup a large portion of the bonuses via the tax code, reflecting the argument that taxpayer money should not be used to subsidize excessive executive compensation. (3)

However, taxpayer subsidization of unreasonable compensation is hardly limited to AIG. (4) Section 162(a)(1) of the Internal Revenue Code, (5) as construed by the IRS, effectively allows publicly traded businesses to deduct an unlimited amount of executive compensation for corporate tax purposes, since salaries are presumably negotiated at arm's length by an independent, profit-maximizing board. In contrast, the IRS has consistently used [section] 162(a)(1) to limit corporate deductions for executive compensation paid by closely held corporations, since closely held corporations lack the commercial checks and balances of their publicly traded brethren. (6) This Comment proposes that, in light of recent scholarship, the IRS has misapplied [section] 162(a)(1), since publicly traded corporations may lack the appropriate oversight and incentive infrastructure to set executive compensation reasonably. Therefore, this Comment proposes that the IRS should use [section] 162(a)(1) to render such compensation nondeductible, just as the Service examines the deductibility of compensation paid by privately held corporations. There are two potential means for the IRS to accomplish the goal of treating equitably the compensation paid by closely held and publicly traded corporations. First, the IRS could examine the compensation paid by publicly held corporations in an identical fashion to privately held corporations. Second, the Service could employ an additional factor in the context of publicly held corporations to assess the traits of the CEO-board relationship, and determine whether an arm's-length relationship actually exists when executive compensation levels are established.

This Comment proceeds in three Parts. The first Part describes [section] 162(a)(1) and the IRS's longstanding interpretation of the statute as limited to only closely held corporations. The second Part examines this interpretation in light of recent scholarship on managerial power and board control, and concludes that the IRS's policy of effectively exempting publicly traded corporations from 162(a)(1) is flawed in light of this scholarship. The third Part explores the new proposed interpretation of [section] 162(a)(1), whereby the IRS would analyze and challenge the deductibility of excessive compensation paid by publicly traded corporations. The IRS could employ the same test for compensation paid by publicly traded corporations as for the compensation paid by their privately traded brethren. Alternatively, the IRS could consider an additional factor which measures the propensity for management influence and capture of the board process of setting executive compensation.

1. THE TRADITIONAL IRS APPROACH TO [section] 162(a)(1)

   Section 162(a) of the Internal Revenue Code declares:

   There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including ... a reasonable allowance for salaries or other compensation for personal services actually rendered. (7) Neither the tax code nor the Treasury regulations define "reasonable allowance for salaries." (8) Nevertheless, the IRS has systematically interpreted 162(a)(1) to apply only to closely held corporations, effectively concluding that "any amount of compensation paid by a publicly held corporation should be per se reasonable," (9) even though [section] 162(a)(1) does not differentiate between the reasonableness of publicly owned and privately held corporations. The original revenue regulations proposed by the Treasury Department immediately following the codification of [section] 162(a)(1)'s predecessor statute disallowed the deduction of compensation which constituted "waste or appropriation of assets of the corporation." (10) However, no subsequent regulations included such a provision, and there appear to have been no enforcement actions taken under those regulations.

   The IRS apparently differentiates between public and private corporations because, with publicly held corporations, "the operation of the normal system of commercial checks and balances arguably is adequate to ensure a proper result so that review by the IRS generally is unnecessary." (11) Such analysis begs the question of what constitutes a "proper result" under [section] 162(a)(1). The "proper result" may be one in which the level of compensation is not motivated by tax avoidance. (12) Alternatively, for g 162 purposes, the "proper result" may be one that preserves the corporate tax base from erosion by self-rewarding managers. (13)

   Available authority lends little support to the tax-avoidance rationale for the nondeductibility of unreasonable compensation. The scant legislative history of [section] 162(a)(1) contains no evidence that tax motivation was intended to play any role in determining reasonableness. (14) Similarly, neither judicial decisions nor the Treasury regulations indicate that the intent behind the compensation is a critical factor in determining whether such compensation qualifies as excessive. (15) Moreover, motivation is not a touchstone for other determinations made under [section] 162(a), which focus upon objective factors such as ordinariness and necessity. (16) There is accordingly no persuasive argument for considering motivation as a controlling factor in determining when a "proper result" has been reached for reasonable compensation purposes. Rather, the tax...