When Is Compensation Reasonable?

Few reasonable compensation cases have existed in the past few years. However, a few are surfacing in audits by the IRS. Section 162(a)(1) of the Internal Revenue Code allows for a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

What is reasonable compensation is a factual issue. The mistake most businesses make is failing to document how compensation is determined. Executive compensation should be reviewed each year and documented in corporate minutes.

In the recent case of Menard, Inc. v. Commissioner, No. 08-2125 (Mar. 11, 2009), Judge Posner reversed the Tax Court’s holding that compensation was unreasonable. The Tax Court only allowed the corporation a deduction of $7 million of the $20.6 million paid to the majority stockholder and CEO and deducted by the corporation. The opinion points out that when comparing the compensation of Mr. Menard with other executives, all of the compensation paid to the other executives must be considered and not just salaries.