An Empirical Assist In Determining Reasonable Compensation In Closely Held Corporations

Abstract

Reasonable compensation is an often litigated issue in the Tax Court.  This frequency of discord arises from the tax code’s lack of definitive criteria for determining “reasonableness.”  Moreover, classification of payments to shareholder-employees of closely held corporations can have a significant impact on their cash flows and tax burdens.  According to §162 of the Internal Revenue Code, reasonable compensation can be deducted from taxable income of a corporation, but amounts paid to shareholders in excess of the reasonable amount should be classified as dividend payments.  Dividend payments are not deductible from taxable income.  The courts use a variety of factors in determining whether the compensation paid qualifies as reasonable.  The main objective of this study is to determine which factors have the greatest influence on Tax Court decisions concerning the reasonable amount of compensation.  Using  logistic regression, the following factors are found to be significant in predicting the court’s decision: comparison of salaries paid to net and gross income, the comparison of salaries with distributions to shareholders, the prevailing rates of compensation for comparable positions in comparable companies, and the employer’s salary policy as to all employees.