Reasonable Compensation (Portfolio 390)


Anne Moran

Adjunct Professor

Georgetown University Law Center

At a glance

I. Introduction
II. Determining Reasonableness Under the Regulations
III. Judicially Developed Factors to Measure Intent and Amount
IV. Necessity for the Actual Performance of Services
V. Situations Where Reasonable Compensation Is Not Deductible
VI. Other Aspects of Reasonable Compensation
VII. Handling a Reasonable Compensation Case
VIII. Tax Planning
IX. $1 Million Limit on Deductible Compensation for Certain Key Executives of Publicly Held Corporations
X. Executive Compensation Under the Emergency Economic Stabilization Act of 2008


Bloomberg Tax Portfolio, Reasonable Compensation, No. 390, analyzes the issues relating to the deduction by an employer for a “reasonable allowance” under §162(a) for compensation paid with regard to personal services rendered. It discusses in depth the factors applied in determining reasonableness, the necessity for the actual performance of services, situations where a deduction for reasonable compensation is not allowable, and other aspects of reasonable compensation. Various tax planning and controversy considerations also are discussed.

The reasonable compensation issue most frequently arises in the context of closely held businesses, which often have an incentive for inflating owner/employee salaries in order to distribute profits as deductible compensation rather than nondeductible dividends. The Portfolio examines in detail the multiple factors used by the IRS and the courts in determining the reasonableness of compensation, and analyzes the trend toward using an “independent investor” standard as the primary indicator of reasonableness.

The Portfolio also discusses the circumstances in which compensation is not deductible despite its reasonableness. These include the standards for determining when employee compensation must be capitalized, including in-house compensation expenses paid in connection with an acquisition, and statutory limitations on compensation under §162(m) of the Code.

The Worksheets include an excerpt from the Internal Revenue Manual instructing Revenue Agents on how to determine the reasonableness of officers' salaries and sample clauses that might be used in employment contracts, board resolutions, and by-laws to require employees to reimburse the employer for any compensation determined to be unreasonable.

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