Comprehensive Tax & Legal Solutions

What is reasonable compensation? Pt. 1

On Behalf of | Dec 6, 2016 | Tax Law

When a company pays employees, it is presumed to some degree, that it pays them only enough to prevent them from leaving and going to work elsewhere. This equation changes when the company is controlled by the individual being paid. The IRS often suspects owners are manipulating pay of insiders as a means of obtaining a tax deduction or reducing the income of the entity.

In a case from this year, the Tax Court disagreed with IRS’s disallowance of the deduction of a large concrete contractor in Arizona. The company had paid two brothers who were also principle owners of the entity $4 million and $7.3 million, as well as $500,000 to an entity that the brothers owned which supplied contract to the business. The company deducted these amounts and the IRS issued a notice of tax deficiency, arguing the amounts were not “reasonable compensation” as allowed under IRC section 162.

The Tax Court looked to the standard used in the Ninth Circuit to define the reasonableness of compensation and applied the five-factor test: “1) the employee’s role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements.”

These factors are somewhat similar to the factors used by the Sixth Circuit, from which any Tax Court appeal would be heard from an Ohio case. The Sixth Circuit uses a nine-factor test derived from the Mayson Case.

Next week, we will look at how the Tax Court view the factors as in the concrete contractor’s case and the difference between the factors used in the Sixth Circuit.