What is reasonable compensation?

• Author: Schlepp, Lisa

Many compensation professionals differ in their interpretation of "reasonable compensation." What is reasonable to a company may not fit what the IRS perceives as reasonable. One of the key issues for closely held C corporations is the definition of reasonable compensation for executives.

In the IRS's eyes, compensation is not just base salad. It also includes cash bonuses or incentives paid, long-term incentives granted, pension plans, profit--sharing plans, as well as any supplemental executive benefit and perquisite programs. The types and combination of plans that companies offer their executives vary widely. Some companies deliver the majority of executive compensation through cash-focused programs, while others offer more benefit and perquisite programs. The inclusion of all these forms of compensation is important when defining reasonable compensation at any organization.

Sec. 162(a)(1) allows companies to deduct "a reasonable allowance for salaries and other compensation for personal services actually rendered" An important aspect of reasonableness is intent. The Service wants to ensure that compensation for services performed is actually compensation, not a disguised dividend. Unfortunately, Sec. 162(a) (1) does not clearly define what "reasonable" means. However, a recent Court of Appeals decision has reviewed the five tests used by the Tax Court to assist companies in deciding what is reasonable. (Note: Adhering to these tests does not guarantee that the IRS will deem the compensation reasonable.) The five tests are:

1. Role and responsibility of the executive;

2. External market analysis of compensation among comparable companies;

3. Financial condition and character of the company;

4. Existence of a conflict of interest (inability of executive to determine compensation); and

5. Use of a formula for calculating compensation.

   An executive's role and responsibilities should be compared to other executives with similar job roles and responsibilities. These comparisons can also be a compilation of skill sets (rather than specific tasks) from other executive roles to best reflect the actual combination of duties.

   An external market analysis among comparable companies is key to establishing reasonable compensation. There are many published surveys that contain data for companies, arranged by scope or size, industry and geography. Compensation professionals also conduct custom compensation surveys to capture specific industry data not...