How to Support a Deduction for Reasonable Compensation

April 3, 2013

Authored by: benefitsbclp

Section 162(a) of the Internal Revenue Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the year in carrying on a trade or business, including “reasonable compensation for personal services actually rendered.”

The reasonableness of compensation is a question of fact.  A taxpayer is entitled to a deduction for salaries or other compensation if the payments were reasonable in amount and are in fact payments purely for services.

Sometimes it is difficult to determine whether amounts are “reasonable,” especially when payments are made to a shareholder-employee or the shareholder’s relatives.

A ruling by the U.S. Tax Court on March 25, 2013, provides a helpful analysis of 10 factors considered by the Court in deciding that amounts deducted as compensation paid to a sole shareholder-employee, his officer-wife, employee-brother and employee-daughter were not reasonable.  (K & K Veterinary Supply, Inc. v. Commissioner, T.C. No. 9442-11, T.C. Memo 2013-84, 3/25/2013).

Compensation Reasonableness Factors

The following is a brief summary of the 10 factors discussed by the Court:

  1. Employee Qualifications.  An employee’s superior qualifications for his or her position with the business may justify high compensation.
  2. Nature, Extent and Scope of Employee’s Work.  An employee’s position, duties performed, hours worked, and general importance to the company’s success may justify high compensation.
  3. Size and Complexity of the Business.  The size and complexity of a taxpayer’s business may warrant high compensation.  This assessment may include consideration of a company’s sales, net income, gross receipts, or capital value, as well as the number of clients, and the number of employees of the company; growth in these areas; and compliance with government regulations.
  4. General Economic Conditions.  General economic conditions may affect a company’s performance.  This factor may be relevant, for example, in connection with adverse economic conditions where the taxpayer may show that an employee’s skill was important to the growth of the company during lean years.
  5. Comparison of Salaries Paid With Gross and Net Income.  Compensation as a percentage of a taxpayer’s gross or net income may be important in deciding whether compensation is reasonable.
  6. Prevailing Rates of Compensation.  The Court considered prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry as “a most significant” factor.  Both the taxpayer and the Commissioner relied on expert reports and testimony to support this factor.
  7. Salary Policy of the Taxpayer as to All Employees.  The amount of compensation paid to all employees may be a factor that supports a high level of compensation.  Whether the company pays top dollar to all of its employees, including both shareholders and non-shareholder employees may be relevant in assessing the pay of shareholder-employees.  Evidence of a reasonable, longstanding, consistently applied all-employee compensation plan may support that the compensation paid was reasonable.
  8. Compensation Paid in Previous Years. The amount of compensation paid in previous years may support a high amount of compensation for a tax year.  This factor will likely only be relevant where the company is deducting compensation in one year for services rendered in prior years.
  9. Comparison of Salaries With Distributions and Retained Earnings.  The reasonableness of compensation may take into account the absence of dividend payments by a profitable corporation.  Because a corporation is not required to pay a dividend, the company’s return on equity may be a better measure of this factor.
  10. Debt Guaranty.  The Court also considered whether an employee personally guaranteed the taxpayer employer’s debt.

The Court considered these various factors and noted that some factors favored the taxpayer, other factors favored the Commissioner, and other factors were either neutral or did not apply.

Expert Reports and Testimony

After giving “due weight” to each of the factors, the Court found the report of the Commissioner’s expert on prevailing rates of compensation, supported by individual company information and financial data, as “persuasive.”  In contrast, the report of taxpayer’s expert provided “guidance of dubious value” because it failed to identify comparable companies by industry or size and the expert did not provide any financial analysis or relevant financial data.

Unreasonable Rent and No Equitable Recoupment

In addition to finding that amounts paid as compensation to the officers (shareholder-employee and his officer-wife) and certain employees (the shareholder’s brother and daughter) were not reasonable, the Court ruled on two related issues.  The Court disallowed a deduction for certain amounts paid by K & K Veterinary Supply, Inc. as rental expenses to a related entity (an entity owned 100% by the shareholder-employee and his officer-wife).  The taxpayer then unsuccessfully argued that the disallowed portions of the compensation and rent were dividends taxable at a lower rate – using the doctrine of equitable recoupment.