3519 / What are the limits on an employer’s ability to deduct compensation paid to an employee?
An employer may deduct all ordinary and necessary business expenses including “a reasonable allowance for salaries or other compensation for personal services actually rendered.”1 “Reasonable” compensation is “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”2 A salary that exceeds what is customarily paid for such services is considered unreasonable or excessive. Items other than wages may be considered in determining whether compensation is excessive. For example, the amount of loans forgiven on key person insurance policies for two top executives when the policies were transferred to them was used in determining whether their compensation was unreasonable.3 Compensation generally is the total amount of compensation paid to an employee, rather than that paid to all employees as a group.4
The issue of reasonable compensation has been almost exclusively a problem in connection with employee-shareholders of closely-held companies. If the IRS finds compensation to be unreasonable, it may reclassify it as a dividend if it had been paid to an employee-shareholder.5 The fact that the corporation had never declared a dividend was a factor in determining whether amounts paid to an individual who was president, director, and sole shareholder were actually disguised dividends.6 Bonuses that are disproportionately high in relation to salaries actually may be dividends in disguise, especially if the employee receiving the “bonus” is the company’s sole or majority shareholder.7 This even includes the value of qualified and nonqualified pension-like benefits, although valuing them for this purpose is not entirely clear.8
1. IRC § 162(a)(1) as amended by PL 115-97.
2. Treas. Reg. § 1.162-7(b)(3).