What is Appropriate Compensation?

Although the future of the tax code is all the talk these days, an article that appears in this month’s The Tax Adviser turned my attention to a different topic.  It’s a discussion of a recent Tax Court ruling about what constitutes reasonable compensation for employees of a closely held corporation.  I may not know what marginal tax rate will be associated with said compensation, but at least this a topic accountants can discuss with clients today without waiting for an act of Congress before expressing an opinion.

According to the article there are five factors that have emerged from Tax Court rulings that form the basis of current thinking about what the IRS will look at in assessing whether compensation is “in the money” or not.  The five factors are:

-       What the employee actually does in the company

-      A comparison with similar positions at similar firms

-      The character and condition of the company

-      Potential conflicts of interest, and

-      Internal consistency of compensation. 

Looking at the first two seems the most objective and therefore what I think most accountants would gravitate toward in terms of emphasis.  (It may be a misplaced stereotype, but I do think accountants tend to be objective.)  In this case though (Multi-Pak Corp., T.C. Memo. 2010-139) the case turned on the interpretation of the potential conflict of interest. 



The test used to assess if there is a conflict of interest is, would a “hypothetical independent investor” think the compensation was reasonable.  The alternative would be our friend H.I. Investor thinking that management is siphoning money out of the company disguised as salary. In this particular case in one year the compensation met the criteria, but in the year the salary payments would have resulted in an almost 16 percent negative return on equity, the court said it agreed with the IRS that the company’s amount of deductible compensation to the CEO had to be reduced. 

Now if we can just here from H.I. on the topic of S-Corporation owners taking too little compensation….