The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 10, May 2003, Panel Publishers, New York, NY.

REASONABLE COMPENSATION?

By Robert W. Wood, San Francisco

One of the most discussed and debated corporate tax deductions of all time is a very simple one: the deduction for reasonable compensation paid. In the context of goals of corporate distributions without dividend treatment, the reasonable compensation deduction has, to use a term from the recording industry, gone platinum. Ultimately, the question is whether the compensation paid is reasonable for the services rendered. This involves reference not only to the particular services performed and their value, but also to the marketplace, both on an industry-wide basis and a geographical basis.

Of course, using the term "reasonable" in the same breath as the multi-million dollar packages which have often prevailed in most of the last few years (at least in public companies) may sound foolish. In the wake of Enron, WorldCom, and various other corporate scandals, many compensation packages for executives have been substantially curtailed. At the same time, virtually all of the tax controversies over the reasonable compensation deduction never occurred in the context of public companies. Indeed, this has always been a private company problem, where the dichotomy between compensation paid and dividends not paid is sharply drawn, where the incentives to prefer ostensibly deductible compensation over clearly nondeductible dividends are quite clear.

It is true that concerns over appropriate compensation levels led to the enactment of Section 162(m). That provision, of course, generally restricts the deductibility of compensation paid to certain key employees to $1 million per year. It has proven almost to be a toothless restriction, however, owing to the exceptions that provision contains for performance-based compensation.

One Million Dollar Cap

Section 162(m) of the Code limits the compensation deduction taken by a publicly-held corporation (even for otherwise deductible compensation) paid to a "covered employee" to $1 million per year. Notably, this limit does not modify the reasonableness requirement, which continues to apply in addition to the $1 million limit. Like so many other provisions, this Code section is full of definitions, including what constitutes a publicly-held company, what constitutes a covered employee, etc.

Plus, there are many types of compensation that are not subject to the $1 million limit and that are simply not counted in determining whether other compensation exceeds $1 million. These include commissions, retirement plan contributions, and various other forms of compensation. Perhaps most generally applicable is the exclusion for performance-based compensation. Although there are various qualifications that must be met before performance-based compensation will be excluded from the $1 million cap, most companies are easily able to skate by these requirements.

Bear in mind that stock options and stock appreciation rights are generally treated as performance-based compensation. While there are certain thresholds that must be met (including outside director and shareholder approval), this represents an awfully important exception. The regulations (final regulations were issued in 1995), deal with the requirements for setting the performance-based goals, the qualifications of outside directors, etc. See Reg. §1.162-27(e)(2), T.D. 8650, 60 Fed. Reg. 65534.

Golden Parachutes, Too

In the M&A field, a topic that belongs on virtually every deal checklist is the applicability of the golden parachute rules. Enacted way back in 1984, Section 280G denies a corporation a capital deduction for any excess parachute payment. Section 4999 imposes a nondeductible 20% excise tax on the recipient. Of course, this excise tax is in addition to the regular income and Social Security tax that the departing executive would expect to pay. The pairing of these two Code provisions ratchets up concern over parachute payments that are made contingent upon a change in control. Like the rules governing the $1 million compensation cap, the golden parachute Code sections contain a plethora of definitions.

Notably, though, our old friend "reasonable compensation" plays a significant part. Once one falls within all of the pejorative definitions of a golden parachute payment, finding that a payment has been made to a disqualified individual, that the payment was contingent on a change in the ownership or control of a corporation (or a substantial portion of its assets), and that the payment had a present value in excess of 300% of historic compensation, one still has an out. If you can prove that the payments were reasonable, then the dreaded golden parachute definition and its nondeductibility designation to the company and excise tax wallop to the employee will simply not apply.

Like so much of the rest of reasonable compensation lore, whether payments to a disqualified individual are actually reasonable compensation for purposes of Section 280G will be determined on the basis of all facts and circumstances. See Prop. Reg. §280G-1, Q&A-40. The proposed regulations identify a number of relevant factors, including the nature of the services rendered, the disqualified persons historic compensation for performing those services, and the compensation of individuals performing comparable services in the absence of a change in ownership or control. Since past services performed (and inadequately compensated), has always been one of the escape clauses in any reasonable compensation fight with the government, it is interesting that the proposed regulations under the golden parachute rules specifically state that with respect to past services, a showing that payments are reasonable compensation under the standards of Section 162 will be treated as clear and convincing evidence that they are reasonable compensation for purposes of Section 280G as well. See Prop. Reg. §1.280G-1, Q&A-43.

Of course, it is not entirely clear that the government helped itself a great deal with this reference to Section 162 standards, since most practitioners had believed that the Section 280G standard involved carrying a heavier burden (to show reasonableness) than is typically applied under Section 162. In any event, it is even possible under Section 280G to show that a payment is made with respect to future services. For future services (to be rendered on or after the date of the change in control or ownership), clear and convincing evidence that the payments represent reasonable compensation will generally not exist if the disqualified individual does not in fact perform the services at that later date. See Prop. Reg. §1.280G-1, Q&A-42(a).

On the other hand, of course, one can be paid specifically for refraining to perform services. An agreement will be treated as an agreement to refrain from services if it is demonstrated with clear and convincing evidence that the agreement substantially constrains the individual's ability to perform services, and if there is a reasonable likelihood that the agreement will be enforced against that individual. See Prop. Reg. §1.280G-1, Q&A-42(b).

All in the Mix

Turning to closely-held businesses where all the action is on this point, let's look at some of the factors that the IRS and the courts have historically applied. Compensation expenses that seem unreasonable in an absolute sense may be justified as reasonable if market conditions dictate that similar compensation be paid to other employees. The following factors are relevant in assessing whether compensation paid should be fully deductible.

• Intent. The intent of the payor is relevant, with an evidenced intent to compensate being useful in upholding treatment of compensation as reasonable. (See Paula Construction Company v. Comm., 58 T.C. 1055 (1972) aff'd., 474 F.2d 1345 (5th Cir. 1973).

• Failure to Pay Dividends. One of the key factors evaluated in determining whether an asserted compensation expense deduction should be allowable as such is whether the corporation has failed to pay dividends or has regularly paid dividends. Because the payment of dividends is the classic and traditional method of paying shareholders for corporate successes as shareholders, the absence of any history of dividends tends to make compensation payments to shareholders suspect. The fact that a corporation has never paid dividends will not automatically result in asserted compensation payments being recharacterized as dividends. (See Rev. Rul. 79-8, 1979-1 C.B. 92.)

However, a failure to pay any dividends is a significant factor in evaluating an asserted compensation expense. What about paying small dividends? Interestingly, the relevance of the payment of dividends is not necessarily tied to their amount: the payment of small dividends, at least on a regular basis, will help to justify the deductibility of amounts paid as compensation, even if the dividends paid over time may not be large. On the other hand, some courts have used an "independent investor" standard, under which the question is whether an independent investor would have invested in stock that pays little or no dividends over time. (See Elliotts, Inc. v Comm., 716 F.2d 1241 (9th Cir. 1983); Shaffstal Corp. v. U.S. 730 F.Supp. 1041 (7th Dist. Of Indiana, 1986); and Webster Tool & Die, Inc. v. Comm. 51 T.C.M. 86 (1985).

Proportionality of Compensation. Another factor is the extent to which compensation is paid on a basis proportionate to share ownership. Obviously, the nexus between the ownership and the amount of payment is clear where compensation is in direct proportion to share ownership. Conversely, payments may look to be much less like a dividend if they are out of proportion to share ownership and are related to other factors, principally the actual services performed and their benefits. (See Kennedy v. Comm., 671 F.2d 167 (6th Cir. 1982); and Bank of Stockton v. Comm., 36 T.C.M. 114 (1977).

• Manner of Determining Payment. The manner in which the payment is determined is obviously relevant in assessing whether or not it is compensation. Thus, if the extent of the payment is determined according to overall results of the company, without regard to the results achieved by the payee, the payment may be treated as a dividend. (See Paul E. Kummer Reality Co. v. Comm., 511 F.2d 313 (8th Cir. 1975); and Nor-CaI Adjusters v. Comm. (1977).

• Timing of Payment. The timing of the payment sought to be deducted as a compensation expense is also relevant. A large payment may be more likely to be justified as compensation if it is made at the end of the year, when results of operations are known, and compensation can be more fairly determined. However, this can backfire. Year-end is also the time when the results of corporate operations are available, and an obvious inference of dividend payment may result. (See Petro-Chem Marking Co. v. U.S., 602 F.2d 959 (Ct. CI. 1979); Owensby &. Kritikos. Inc. v. Comm., 50 T.C.M. 29 (1985).

An important factor here, as in the entire reasonable compensation area, is to maintain appropriate documentation showing the basis for the compensation, specific actions that justify it, comparable levels of compensation in other companies, and other data that offer evidence of reasonableness.

• Nonshareholder Salary Scales. The fact that nonshareholders receive a certain compensation level for similar work, perhaps even as high as that paid to shareholders is highly relevant in assessing whether an asserted compensation expense deduction should be allowable. (See Home Interiors &. Gifts. Inc. v. Comm., 73 T.C. 1142 (1980); and Central Freight Lines. Inc. v. Comm., 35 T.C.M. 85 (1976)). However, where the services provided by the nonowner employees are not comparable in scope or quality to the services provided by the owner employees, the relevance of compensation paid to the nonowner employees is not high. (See Clymer v. Comm., 47 T.C.M. 1576 (1984); and Lundey Packing Co. v. Comm., 39 T.C.M, 541 (1979)).

• General Salary Scales. Salary scales are relevant from two perspectives. One is simply the salary scale of the particular company with respect to all employees. A generous salary scale for nonemployee owners (and for employees in general) may help to contraindicate a disguised dividend in the form of compensation to employee/shareholders. (See Home Interiors &. Gifts. Inc. v. Comm., 73 T.C. 1142 (1980)). Even more important, the salary scale in the industry as a whole is relevant in determining whether compensation is reasonable under the circumstances. (See Reg. §1,162-7(b)(3))

• Qualifications of Employee. The qualifications of the employee are clearly relevant in assessing the reasonableness of compensation. (See Kennedy v. Comm., 671 F.2d 167 (6th Cir. 1992); and Dahlem Foundation. Inc. v. Comm., 1566 (1970), acq., 1971-1 C.B. 2.) A highly qualified employee may be paid more than a minimally qualified avoid dividend one.

• Corporate Formalities. The extent to which compensation is payable pursuant to formal corporate agreements is also important. A detailed employment or consulting agreement, corporate resolutions, provisions for bonuses, and the like, are all relevant, although their absence will not necessarily doom compensation to dividend treatment. (See Mayson Manufacturing Co. v. Comm., 178 F.2d 115 (6th Cir. 1979)). Yet, some courts have viewed formal board resolutions as bearing little weight in the case of closely held corporations. (See e.g., Boyle Fuel Co. v. Comm., 53 T.C. 162 (1969). acq., 1970-1 C.B. xv.) Nevertheless, the safest course is to pay compensation only pursuant to formal arrangements.

Reasonable Compensation?, Vol. 11, No. 10, The M&A Tax Report (May 2003), p. 4.