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What is reasonable compensation? Pt. 2

Last week, we looked at the factors the Tax Court uses to determine if compensation paid to employee/owners of a company qualify as "reasonable." In a case involving a concrete contractor, the court found that the five-factor test supported the company's assertion that the payment of $4 million and $7.3 million to two brothers who ran the company was reasonable.

The court examined each factor and found they either supported the reasonableness or were neutral. The explained how the business had greatly expanded under the management of the two brothers, how the company's reputation was bolstered by the very knowledgeable and hands-on approach to their management, and how the company used the same compensation formula every year from the early 1990s through the year in question, 2004.

Because the entity was wholly-owned by the two brothers and their mother, the conflict of interest factor received scrutiny. Here the facts supported the company, as the return on equity was within 0.3 percentage points of the industry average. The court found the expert relied on by the concrete business more persuasive than the expert and industry comparisons used by the IRS.

The Sixth Circuit test has nine factors, which are generally similar to those condensed in the five-factor test. That test, had it been used in this case, likely would have come to a similar conclusion, as it breaks out in more detail factors similar to the shorter test.

For instance, the first factor, "the employee’s role in the company" would be covered by first two factors of the Sixth Circuit's test, where it asks, "The employee’s qualifications," and "The nature, extent, and scope of the employee’s work."

If you have had a Section 162 compensation deduction disallowed by the IRS as not being "reasonable," you will want your tax attorney to focus on the test used by the courts in your circuit and to effectively marshal the facts of your situation to support your action for every element of the tests.

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