Establishing Fair and Reasonable Compensation

The issue of reasonable compensation versus unreasonable compensation comes up frequently in IRS audits of businesses and tax-exempt organizations, shareholder meetings, shareholder disputes, and media coverage of executive performance.

When determining whether a person’s compensation is reasonable, Stephen D. Kirkland looks at many factors. Compensation includes not only the base pay of an employee, but also bonuses, stock options, golden parachutes, commissions, and employee benefits. These employees may work in closely-held businesses (such as family-owned businesses), large companies, private foundations, or publicly-traded corporations. The employee may also work for a charitable organization, including a hospital.

Paying unreasonable compensation may result in loss of tax-exempt status or other tax issues. It may also be unfair to donors, minority shareholders, or lenders.

To establish reasonable compensation, Stephen D. Kirkland looks at an employee’s input, such as long hours, special skills, years of experience and education that he or she brings to the job. Stephen also examines the employee’s output, the results he or she achieves, since after all, pay for key employees should be performance based. Some business owners’ pay includes catch-up pay from earlier years, which may also be used to determine whether the compensation is reasonable.

For publicly-traded companies, the Internal Revenue Code has set a maximum deduction of $1 million per year for compensation paid to a covered employee. The covered employees are the corporation’s Chief Executive Officer and the four highest-paid officers other than the CEO. Certain types of compensation are not subject to this $1 million limit, including commissions, performance goal remuneration, contributions to qualified retirement plans, tax-excludable employee welfare benefits, and certain amounts under a pre-1993 written contract.

Stephen D. Kirkland, CPA has served as an expert witness in U.S. Tax Court cases involving reasonable compensation issues. Please contact him if you need help determining fair and reasonable compensation.