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What is reasonable compensation?

Many compensation professionals differ in their interpretation of "reasonable compensation." What is reasonable to a company may not fit what the IRS perceives as reasonable. One of the key issues for closely held C corporations is the definition of reasonable compensation for executives.

In the IRS's eyes, compensation is not just base salad. It also includes cash bonuses or incentives paid, long-term incentives granted, pension plans, profit--sharing plans, as well as any supplemental executive benefit and perquisite programs. The types and combination of plans that companies offer their executives vary widely. Some companies deliver the majority of executive compensation through cash-focused programs, while others offer more benefit and perquisite programs. The inclusion of all these forms of compensation is important when defining reasonable compensation at any organization.

Sec. 162(a)(1) allows companies to deduct "a reasonable allowance for salaries and other compensation for personal services actually rendered" An important aspect of reasonableness is intent. The Service wants to ensure that compensation for services performed is actually compensation, not a disguised dividend. Unfortunately, Sec. 162(a) (1) does not clearly define what "reasonable" means. However, a recent Court of Appeals decision has reviewed the five tests used by the Tax Court to assist companies in deciding what is reasonable. (Note: Adhering to these tests does not guarantee that the IRS will deem the compensation reasonable.) The five tests are:

1. Role and responsibility of the executive;

2. External market analysis of compensation among comparable companies;

3. Financial condition and character of the company;

4. Existence of a conflict of interest (inability of executive to determine compensation); and

5. Use of a formula for calculating compensation.

An executive's role and responsibilities should be compared to other executives with similar job roles and responsibilities. These comparisons can also be a compilation of skill sets (rather than specific tasks) from other executive roles to best reflect the actual combination of duties.

An external market analysis among comparable companies is key to establishing reasonable compensation. There are many published surveys that contain data for companies, arranged by scope or size, industry and geography. Compensation professionals also conduct custom compensation surveys to capture specific industry data not currently in published surveys to ensure viable matches. The statistical level (e.g., median or 75th percentile) in the market data at which the matches are made is also an important comparability factor. Usually, this is determined based on a company's compensation; if the company does not have a specific strategy, this is a good time to formulate a "road map" for future comparisons.

A company's financial condition and makeup can affect compensation comparisons. If the company's financial performance is outstanding, comparisons should be made against other companies with good financial performance. Usually, specific financial factors are chosen and replicated on a year-by-year basis to ensure consistency in reasonable compensation reviews.

Companies need to ensure there is no conflict of interest among the executives and how their compensation packages are determined. There are two key points to consider. First, engaging a third party to perform the compensation review will help substantiate an objective opinion on compensation packages. This review usually has the breadth and depth of information needed to satisfy the IRS. Next, company executives should not determine their own pay. The outside compensation review is a start, but some companies have established committees to look at compensation issues as well.

Using a strategy and one or more formulas to help determine compensation levels will take some of the subjectivity out of the process. This is especially important in variable compensation plans (e.g., annual bonus and long-term incentives). Typically, it is best to link performance and financial goals to a formula to determine plan payouts. Importantly, this formula should not result in distributions in the same proportions as ownership. The way to avoid this issue is to make sure the incentive target and opportunity are based on market data. These considerations can be achieved in a variety of ways that will avoid the subjectivity of a "discretionary" plan and any "perceived" dividends.

The key points that seem to concern the Service are external comparisons and non-formula-driven incentive plans.

A few more additional factors can be considered when reviewing compensation:

1. Existence of loans between the company and executives;

2. Dividend history of the company; and

3. Salary history of the individual executives.

These factors are helpful to review with the five core tests and should indicate any issues.

The most important points to consider when reviewing compensation for reasonableness include:

* Thorough documentation of all compensation programs and policies, as well as annual compensation performance reviews;

* Determination of compensation programs and policies as if there were an independent institutional investor to satisfy; and

* Consistency in how compensation programs are reviewed, determined and administered (which is why objective, formula--driven calculations are the best).

"Red flags" regarding a company's compensation plans should be brought to the attention of the company's compensation professional to help determine the best approach (see Friske and Smith,"The Status of the `Independent Investor' Test in Reasonable Compensation," 31 TTA 406 (June 2000)).

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Article Details
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Author:Schlepp, Lisa
Publication:The Tax Adviser
Geographic Code:1USA
Date:Feb 1, 2001
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