Definitions — Being Reasonable

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Image source: Public domain via Wikimedia Commons, provided by the National Archives and Records Administration

Image source: Public domain via Wikimedia Commons, provided by the National Archives and Records Administration

When it comes to compensation, what’s “reasonable?” Because there’s no real definition in the tax code or in the real world, the issue comes up repeatedly in court. (And on Taxing Lessons. See here and here.)

The answer varies by entity type and can encompass too much compensation as well as too little.

For example, in the case of a C corporation, shareholders may want to take more compensation from a profitable company to avoid paying nondeductible and double-taxed dividends. Owners of subchapter S corporations generally prefer to take less salary and more nontaxable distributions. Executives of nonprofits may not realize that compensation includes benefits such as loans made at below-market interest rates.

In each situation, the results can be harsh. C corporation shareholder compensation can be reclassified as dividends, causing the corporation to lose a deduction and incur penalties. S corporation owners may owe back payroll taxes as well as penalties and interest. Nonprofit organizations who pay executives “excess” compensation may be subject to excise taxes and potential loss of nonprofit status.

Reasonable compensation rules also affect other tax benefits, such as the federal income tax credit for research and development costs.

In T.C. Memo. 2014-201 (Suder), one of the questions before the court was whether a CEO’s salary met the definition of reasonable compensation for purposes of claiming the research credit.

The taxpayer, an inventor and designer of telephone systems for small and midsize businesses, claimed flow-through research tax credits on his personal return. The credits amounted to $445,987 for 2004, $440,306 for 2005, $454,526 for 2006, and $442,557 for 2007.

Nearly 95% of the qualified expenses for the credits arose from wages paid for qualified services. The taxpayer was the company’s most highly compensated employee. He received wages of $8,674,815 for 2004, $10,954,175 for 2005, $10,548,022 for 2006, and $10,502,584 for 2007. Eighty percent of his wages were allocated as qualified expenses for the research credits.

The IRS said the taxpayer’s wages were not reasonable (in the context of claiming the research credit).

The court considered a nine-factor test in reaching a conclusion. The four deciding factors were:

1. Qualifications and Work Duties

The taxpayer started the business in 1987 out of his garage as a one-person operation. By 2004 the company had 125 employees and nearly $40 million in gross annual revenue.

The taxpayer was semi-retired by 2004 and worked an average of 20 to 30 hours per week from 2004 through 2007, though he continued driving product development during that time.

2. Wages Relative to Stockholdings and Income

The taxpayer was the company’s most highly compensated employee from 2004 to 2007. He was paid $8,674,815 for 2004, $10,954,175 for 2005, $10,548,022 for 2006, and $10,502,584 for 2007. His wages constituted roughly two-thirds of total qualifying wage expenses for 2004 through 2007.

His wages were approximately 4-1/2 times, 6 times, 5-1/2 times, and 5-1/2 times the company’s ordinary business income (line 21 of Form 1120S) for 2004 through 2007, respectively.

3. Wages as Research Expenses

The taxpayer’s wages comprised a base salary and bonuses. The bonuses were based on factors that included the company’s growth, overall value, and cash flow. The company did not pay the taxpayer royalties and there was no evidence that his wages were tied to his contribution to research and development.

4. Wages Compared With the Wages of Other CEOs

The IRS expert compared the taxpayer’s salary to compensation paid by similar companies to similar CEOs performing similar services, and concluded that reasonable wages were $1,046,153 for 2004, $1,018,185 for 2005, $1,078,203 for 2006, and $1,131,436 for 2007.

The taxpayer’s expert used six industry compensation databases and included four components in his compensation analysis—a base salary, an annual incentive, a long-term incentive, and royalties on gross revenue. He computed reasonable compensation for the taxpayer to be $11,035,735 for 2004, $111,321,086 for 2005, $12,179,498 for 2006 and $12,814,798 for 2007.

The court said it was not appropriate to include a royalty component in the comparison since royalties are not remuneration for services performed by an employee. (A royalty is generally defined as a payment that fluctuates with a licensee’s usage of a licensor’s intellectual property, such as a payment based on the quantity of patented products sold.)

Without the royalties, the reasonable compensation determined by the taxpayer’s expert was $2,366,090 for 2004, $2,439,174 for 2005, $2,558,098 for 2006, and $2,643,907 for 2007.

Reasonable Compensation table

 

What do you think?

Based on the four factors,


THE COURT’S DECISION

For a full explanation, hover your mouse over the link

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided to read the entire case.

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Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!
The court found the taxpayer’s compensation (as used for the credit reported on the tax return) for 2004 through 2007 unreasonable under section 174(e). The court accepted the computations of the taxpayer’s expert as reasonable.

Factor 1. The taxpayer’s part-time work schedule raises doubt as to the reasonableness of his compensation.

Factor 2. The taxpayer’s high compensation relative to the company’s income suggests his compensation was, at least in part, unreasonable.

Factor 3. There is no evidence in the record the taxpayer’s wages were tied to his contribution to research and development at the company. We note, for example, the taxpayer’s wages were significantly higher in 2004 through 2007 than they had been in prior years, notwithstanding the fact that he was not named as an inventor on any new patent applications filed from 2004 to 2007.

Factor 4. We accept the taxpayer’s expert’s computations of base salaries, annual incentives, and long-term incentives as reasonable amounts that someone in the taxpayer’s position would ordinarily be paid for performing activities similar to those he performed.

Editorial Note: This tax court memo contains issues not discussed here, including a discussion of whether the research and development activities constituted “qualified research” for purposes of the credit.

In addition, the court allocated the taxpayer’s salary between time spent performing qualified services and nonqualified services.

Please read the entire case.

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