Sustaining a Deduction for Reasonable Compensation

By Barragato, Charles A. | The CPA Journal, May 1991 | Go to article overview

Sustaining a Deduction for Reasonable Compensation


Barragato, Charles A., The CPA Journal


With the demise of the tax shelter and the redirecting of IRS attention, the practitioner is more likely to face the issue of reasonable compensation when providing services to a closely-held corporation. Any disallowed unreasonable portion of compensation paid to a stockholder wil be deemed a dividend to the recipient and generate an addition to the corporation's taxable income. Disallowance of a portion of the compensation deduction may then result in adjustments to claimed qualified plan contributions, modification of withholding taxes, penalty and interest accruals, and the potential for an accumulated earnings tax issue. The aggregate effects of a disallowance can be devastating.

Recent judicial standards are reviewed in this article to provide the practitioner with a concise reference tool for use in justifying a compensation deduction.

THE STARTING POINT IS QUITE SIMPLE

The concept of reasonable compensation finds its origin in Sec. 162(a)(1), which provides:

". . . a taxpayer may deduct ordinary and necessary business expenses, including a reasonable allowance for salaries and other compensation for personal services actually rendered."

This definition was expanded by Reg. Secs. 1.162-7(a), (b)1 and (3) to require that the amount claimed be solely for services and that it be reasonable, i.e., limited to the amount that would ordinarily be paid by an enterprise under like circumstances.

Because the determination of reasonable compensation is purely subjective under the statute, taxpayers and the IRS locked horns at an early stage with respect to this issue. Numerous situations arose where taxpayers presented compelling evidence substantiating a claimed deduction, yet were unsuccessful throughout the IRS's administrative process. It became clear that taxpayers and practitioners faced ancillary issues such as personal opinion and bias at the administrative level. Generally, it was only through expensive and time consuming court proceedings that taxpayers could ultimately prevail. Case law quickly develped, establishing both qualitative and quantitative precedents to be considered.

CASE LAW DEVELOPMENT

Most areas of the tax law saddle the taxpayer with the burden of proof on a particular issue. However, in the area of reasonable compensation, this concept has been modified to the taxpayers' benefit by judicial precedent. Initially, there is a presumption that the IRS's determination concerning a compensation issue is correct. The taxpayer is then given the opportunity to present proof to substantiate the claimed deduction. When the taxpayer introduces uncontradicted, unimpeached testimony from well qualified, impartial witnesses sustaining its compensation deduction, the burden of proof shifts to the IRS.(1) Thus, the taxpayer has the ability to turn the tide in this highly subjective area.

Many tax court rulings have required that reasonable compensation paid to an employee be determined in accordance with the particular facts and circumstances of each case,(2) evaluated on a year-by-year basis. Therefore, an allowance or disallowance in any given year does not in itself provide precedent for other years. The courts have developed a litany of factors, through a variety of different cases, to be used by taxpayers and the IRS in the analysis of compensation issues. One of the first cases to provide comprehensive criteria was Mayson Mfg. Co. in. Commr., 49-2, USTC para. 9467, 178 F2d. 115 (6th Cir. 1949). The factors enumerated by the court for consideration included:

* Employee qualifications; * Nature, extent, and scope of employee's work; * Size and complexities of the business; * Comparison of salaries paid with gross and net income of the business; * Prevailing economic conditions; * Comparison of salaries with distributions to stockholders; * Prevailing rates of compensation for comparable positions in comparable concerns; * Salary policy of taxpayer as compared to all employees; and * In small corporations with limited officers, the amount paid to the particular employee in prior years. …

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