The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 5, December 2000, Panel Publishers, New York, NY.


By Robert W. Wood

Over the years, the question of what compensation is "reasonable" has plagued taxpayers. It may be strange to refer to any compensation in this era of seven and eight digit CEO packages as "reasonable" by any normal measure of the word. Webster, surely, would not define reasonable in this fashion in his dictionary. Yet, for tax purposes, we know that virtually anything goes. The vast majority of problems historically occurred only with closely held companies, where the dichotomy between compensation deductible to the company on the one hand, and a dividend nondeductible to the company on the other, was most clear.

Recently, Section 162(m) provided a new overlay on reasonableness, with its $1 million deduction limit, subject to a variety of exceptions. Section 162(m) provides that publicly held corporations are not allowed a deduction for an employee's compensation in excess of $1 million. There are a variety of exceptions and limitations to this, including the fact that this cap applies only to certain "covered employees." The class of covered employees generally includes the CEO and the persons who are the four most highly compensated officers of the company.

The big question, though, is what is reasonable, although in the language of Section 162(m), this is described as remuneration which is performance-based. Compensation that is performance-based and therefore outside the scope of the Section 162 $1 million limit bears an uncanny resemblance to the "reasonableness" notion that has existed in the law for decades.

Performance-Based Competition

Section 162(m) excludes from its $1 million cap compensation that is performance-based. A compensation committee must establish performance goals, and the make-up of the compensation committee must satisfy certain requirements. Basically, the compensation committee must consist of two or more outside directors. An outside director is a person who: (a) is not presently an employee of the corporation or a related company; (b) is not a former employee still receiving compensation for prior services (other than under a qualified pension plan); (c) was not an officer of the corporation or related companies at any time; and (d) is not currently receiving compensation from the corporation in any capacity other than as a director.

Apart from the make-up of the compensation committee, the compensation that is paid must be performance-based. As the name would suggest, this is simply compensation that is based solely on attaining one or more performance goals. The proposed regulations set forth the types of performance goals that will satisfy this requirement. Perhaps most significantly, the performance goals must be pre-established (they must be in writing no later than 90 days after commencement of the services to which the performance goals relate). The outcome of the goal must be substantially uncertain when the committee establishes the goal.

There are a variety of other requirements for performance goals, including the fact that they must be objective, they must be defined broadly to include performance standards applied to the individual employee, business unit or corporation as a whole, and the performance goals must state the method for computing the compensation payable if the goals are met.

There are a number of other requirements which must be met before the $1 million cap of Section 162(m) can be successfully circumnavigated. However, most companies have found that the detailed performance goal procedures generally make Section 162 and its cap not much of a threat. In some ways, the fact that there are detailed hurdles in Section 162(m) makes the deductibility of the payments all that much more secure, since, unlike the context of the typical closely-held company, it makes full documentation appropriate and even necessary.

That brings us to the topic of when things are typically not documented, when reasonable compensation is an issue in the closely-held company.

What's Reasonable?

The amount that is reasonable is still an intensely factual determination. Not many cases actually make it through the court system on this point. A very recent example of one that not only went through Tax Court, but also through appellate court, is LabelGraphics, Inc. v. Commissioner, No. 99-70164, Tax Analysts Doc. No. 2000-21055, 2000 TNT 155-10 (9th Cir., Aug. 8, 2000). LabelGraphics involved a corporation that produced pressure sensitive identification materials such as labels and graphic overlays, specializing in selling to high-tech companies. The company claimed a deduction for $878,913 in compensation for one year paid to the president and sole shareholder. The IRS sought to cut this amount by more half, thus denying the company a big part of its deduction.

The company was founded in 1978 by Lon Martin as a sole proprietorship, and incorporated two years later in 1980. The year of the questioned deduction was 1990. Two years after 1990, Martin sold his shares to his son. The IRS did not think the issue moot, however, and moved to attack the deduction claimed in 1990. The company was quite successful, gross receipts growing in each of its first eight years, then declining slightly over the next two years due to market conditions.

During the last two years the company developed a process for producing clean room labels. Mr. Martin was instrumental in that development and was the heart of the company, setting corporate policy, monitoring quality control, compliance, and even external relationships. As with many small companies, the founder was given a salary plus a bonus. Martin's bonus in 1990 was substantially higher than normal, $722,913. Bonuses were also paid to the founder's son and daughter-in-law.

The bonuses were deducted by the company under Section 162 and the IRS disallowed most of Martin's compensation (the Service disallowed $633,313).

Tax Court Finds its Own Figure

The Tax Court held that the corporation could deduct $406,000 of the $878,900 that it paid in compensation to Martin, concluding that the balance was not reasonable. As with all such cases, the Tax Court had to go through the analysis of the skills of Martin and his relationship with the business. To some extent, a particularly good year can be harmful. The court was struck by the fact that the $722,900 paid to Martin was nearly three times the amount of Martin's largest prior bonus. LabelGraphics acknowledged that this bonus was unusually high. In what was perhaps the largest failing LabelGraphics made in its case, it failed to prove that any portion of this extraordinary year was attributable to prior year's inadequate compensation. Inadequate compensation for a prior year is often the lynchpin of any claim for reasonable compensation.

One of the other important standards in a reasonable compensation case is what independent investors would do. The Tax Court found that because of the 1990 bonus paid to Martin, LabelGraphics suffered a loss and had a negative 6.19% return on equity for 1990. The court posited that an independent investor would not be satisfied with that negative return on equity, especially when the bonus equaled about 45% of the investor's equity in the company.

For all this, though, the court refused to sustain an accuracy-related penalty for substantial understatement of income tax, finding that LabelGraphics made an adequate disclosure of the amounts on its tax return.

When the matter finally reached the Ninth Circuit, the circuit court found that the Tax Court did not clearly err in determining the amount of reasonable compensation. The court used a two-pronged test to determine if the compensation was actually compensation or was something else:

Here, given Martin's role in the company, a comparison of his salary with other companies' salaries for similar services, the character and condition of the company, and the potential conflicts of interest, the circuit court found that the Tax Court did not err in its determination of what constituted compensation.

Note: All too few cases concerning reasonable compensation are decided these days. One of the most important elements to remember is the doctrine that allows past compensation to be taken into account, with no time limit. So, it is possible to show that a founder or other key person was paid inadequately for the last twenty years, and that a large payment makes up for this. A good deal of statistical information can help. It is true that what an independent investor would do is often referred to as a benchmark as well. Particularly when dividends have historically not been paid by a company (something that usually is not done in a closely held company), the independent investor standards will work against this.

Independent Investor Test

Some courts have determined that corporate profits (after deduction for salaries to shareholder-employees) should be considered in determining whether compensation paid is "reasonable." One of the best-known cases is Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983). There, the court stated that if the "company's earnings on equity remain at a level that would satisfy an independent investor, there is a strong indication that management is providing compensable services and the profits are not being siphoned out of the company disguised as salary." Id. at p. 1247. Other courts have noted that the independent investor test may be a factor, in some cases a substantial factor in defining reasonableness. For example, see L&B Pipe & Supply Co. v. Commissioner, T.C. Memo 1994-187 (1994).

Applying the independent investor test is essentially a matter of considering the total return to the investor, including dividends, stock appreciation, and corporate earnings. That means there can be some flexibility. See Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142 (1980). Of course, the IRS takes the position that a low rate of return on invested capital may support an inference that payments to shareholders constitute a distribution of profits. The IRS has generally been required to show that this low rate of return during the years in question was caused by unreasonable compensation, and not for other reasons, such as fluctuating business cycles. For example, see Bringwald, Inc. v. U.S., 334 F.2d 639 (Ct. Cl. 1964).


It is unlikely that the reasonable compensation doctrine will pass from our society, at least under our current tax system. Even though practitioners may only occasionally see these issues, they are still very much alive. And, especially when the compensation has been paid either before or after a takeover, other considerations (capitalization concerns and/or golden parachute concerns) will put a special spin on this still vital field.

Just What Is Reasonable Compensation Anyway?, Vol. 9, No. 5, The M&A Tax Report (December 2000), p. 2.