Reasonable Compensation: Circuit Court Differences Create Confusion and Inconsistency

An incentive exists for closely held C corporations to pay owner-employees higher salaries and lower dividends to avoid the double tax on corporate income. For this reason, the Internal Revenue Code and Treasury Regulations limit corporate compensation deductions to “reasonable compensation”; however, primary tax authorities do not provide a standard definition, leaving the courts to determine what is reasonable and what is not. The courts have generally followed two approaches: a multi-factor test and an independent investor test. We provide an in-depth exploration of reasonable compensation case law with a focus on disparity within and across court circuits. We supplement this exploration with an analysis of whether multi-factor determined court outcomes would have changed under the independent investor test. Overall, our findings show disparity in reasonable compensation court determinations within and across circuits and highlight the need for a consistent standard to create tax equity in employee-shareholder compensation practices.