March 8 2022

US Tax Court Uses Multifactor Approach in Determining Deductible Reasonable Compensation

Source: IBFD Tax Research Platform News

The US Tax Court has ruled that the US Internal Revenue Service's (IRS's) disallowance of deductions for excess compensation was justifiable. The Tax Court, however, granted the taxpayer compensation deductions greater than the IRS had permitted.

The Tax Court stated that, while corporations may deduct reasonable allowances for salaries or other compensation, the determination of what constitutes reasonableness is a question to be determined from all the facts and circumstances of each particular case (see Martens v. Commissioner, 934 F.2d 319).

The Tax Court also cited US Treasury Regulations section 1.162-7(b)(3), which provides that reasonable and true compensation is an amount "as would ordinarily be paid for like services by like enterprises under like circumstances."

In determining an appropriate compensation, the Tax Court used the multifactor approach (MFA) that the US Court of Appeals for the Fourth Circuit, to which an appeal of the present case would lie, utilizes.

The MFA requires an analysis of the following factors:

  • the employee's qualifications;
  • the nature, extent and scope of the employee's work;
  • the size and complexities of the business;
  • a comparison of salaries paid with gross income and net income;
  • the prevailing general economic conditions;
  • comparison of salaries with distributions to stockholders;
  • the prevailing rates of compensation for comparable positions in comparable concerns; and
  • the salary policy of the taxpayer as to all employees.

In rendering its opinion, the Tax Court pointed out that no single factor was decisive but instead weighed the totality of the facts and circumstances. In this particular case, the most dominant factors were:

  • the comparable pay by comparable concerns;
  • the distribution history;
  • the process used in setting the compensation in the years at issue; and
  • the involvement by the employee at issue (i.e. the taxpayer's chief executive officer (CEO) and shareholder) in the taxpayer's business.

Furthermore, the Tax Court also gave greater weight to the testimony of the IRS' valuation expert than those of the taxpayer who utilized the independent investor test.

Note: The independent investor test is another standard that certain courts utilized. This test considers what an inactive, independent investor would be willing to compensate the employee.