Wednesday, January 16, 2013

Section 162 Reasonable Compensation

What does the IRS consider reasonable compensation?

§ 162(a)(1) allows for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

This section often comes into play because the double taxation of corporations. If the officers and executives of a corporation are substantially identical with its major shareholders, a temptation may arise to distribute some of the earnings of the corporation under the label of additional compensation for services, rather than under the dividend label to save on taxes.

The reduction in dividend tax lessens that tax advantage of compensation over dividends, but in many situations a significant tax advantage for compensation remains. There are several exception for performance related compensation. However, what is reasonable compensation for the IRS is subject to lots of debate between the taxpayer and IRS on audit.

To find what is reasonable compensation, look at the market return. If investors are obtaining a high rate of return, executives should be compensated. Courts approach it many different ways. No indication how any of the factors should be weighed. Courts are not human resource departments. The test is unpredictable and leads to arbitrary conclusion.

No Super Personnel Department for Closely Held Corporation. The primary purpose of § 162(a)(1), which is to prevent dividends (or in some cases gifts), which are not deductible from corporate income, from being disguised as salary, which is. The IRS limits the amount of salary that a corporation can deduct from its income primarily in order to prevent the corporation from eluding the corporate income tax by paying dividends but calling them salary because salary is deductible and dividends are not.

Unreasonable compensation cases with can get very sticky. This is a lot like valuation, and courts rely heavily on expert testimony. How do you figure out if the compensation is reasonable? The IRS can really go after companies for unreasonable compensation and appeals might be necessary.

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