The question of reasonable compensation is frequently debated in shareholder disputes, divorces and IRS audits. Owners’ compensation is a discretionary expense that controlling owners can alter. It can vary significantly from company to company depending on many factors, including the owner’s education, licenses, training and salary history; the business’s size and financial health; the business’s location; industry trends; and the state of the economy.
A valuator can help a company estimate a range of reasonable compensation that eliminates “owner bias” and adjusts income to a level that reflects economic reality based on objective market data.
The IRS and the Tax Court weigh in
It’s not unusual for the IRS to question the compensation that closely held companies pay their owners. But in a 1983 decision, Elliots Inc. v. Commissioner, and in several subsequent decisions, including Multi-Pak Corp. v. Commissioner, the Tax Court provided some guidance, articulating five factors, or tests, that often come into play in determining whether an owner-employee’s compensation is reasonable:
The Tax Court may apply the “independent investor test.” According to the test, if the company’s earnings on equity after payment of the owner’s compensation would satisfy a hypothetical independent investor, the compensation would probably be reasonable.
Of course, reasonable replacement compensation may, on occasion, differ from the criteria the Tax Court uses to challenge executive compensation. In the business world, for instance, it may be possible to justify paying much more than what might be considered reasonable to maintain the operation if the company requires special talents to improve or dramatically grow. There are always exceptions, and reasonableness is, to some extent, in the eye of the beholder. But typically, reasonable compensation is objective, unbiased and based on relevant empirical data.
But the Tax Court’s decisions and analysis provide a valuable roadmap for withstanding IRS challenges. Business owners, attorneys and other interested parties can benefit from understanding the five factors the Tax Court takes into account when evaluating reasonableness of an owner’s compensation. Qualified experts apply these factors — and others — to help enable business owners and attorneys to prevail in court.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.