IRS Publication - Reasonable Compensation
In 2014, the IRS released a 26-page publication titled “Reasonable Compensation – Job Aid for IRS Valuation Professionals.” However, the publication specifically indicates that it is not an official pronouncement of law and like the Internal Revenue Manual cannot be used, cited, or relied upon as such.
In the Publication’s “Background” it States: The Reasonable Compensation issue usually involves a determination of whether the amount of compensation paid is reasonable so that it is deductible under section 162 of the Internal Revenue Code for income tax purposes. In some cases, the Reasonable Compensation issue comes up when the amount of compensation paid may be lower than reasonable to avoid the payment of employment taxes.1 For tax-exempt entities, the issue involves the application of section 4958, taxes on excess benefit transactions, and reflects a concern that excessively high compensation may unduly enrich officers, directors, trustees or key employees of the tax-exempt entity at the expense of the qualified charitable purpose.
(1) According to Treas. Reg. § 1.162-7(a), "The test of deductibility in the
case of compensation payments is whether they are reasonable and are in fact
payments purely for services."
Valuation Approaches
The publication includes three approaches to determine reasonable compensation:
-
Market Approach – How much compensation would be paid for this same position, held by a nonowner in an arms-length employment relationship, at a similar company.
-
Income Approach - Is based on an "Independent Investor Test," which seeks to determine whether an independent investor would be satisfied with his/her return on investment when looking at the financial performance of the taxpayer's business in conjunction with the subject employee’s level of compensation.
-
Cost Approach – Is based on the hours spent by the employee down to the various duties performed, quantifies the amount of time devoted to the different responsibilities, and compares the employee’s salary to market compensation for comparable positions.
The valuations approaches require access to local labor statistics and may be best left to professionals who provide reasonable compensation evaluation services.