Opinion Letters on Reasonable Compensation
Stephen Kirkland helps businesses and charities design compensation and rewards systems, create incentives, and determine appropriate levels of compensation for their employees. This involves many factors including cash flow concerns, connecting rewards with goals, tax issues, and maintaining confidentiality (when possible).
Stephen assists with job analysis, finding comparability data, and job descriptions. To do so, one must look beyond titles, and understand what a worker really does, what his or her responsibilities are, what authority he or she has, what the expectations are, and whether he or she meets or exceeds expectations. Stephen also considers key intangibles such as attitude, loyalty, skills, judgment, relationships and other elements of professional goodwill.
Stephen also provides comparability data and opinion letters on the reasonableness of compensation paid to executives and other key employees at hospitals, foundations and other tax-exempt organizations. The comparability data and opinion letters are especially helpful to exempt organizations subject to the excess benefit transaction rules of Internal Revenue Code section 4958. These opinion letters help promote efficiency and fairness, and may prevent the IRS from imposing excise taxes under section 4958 which can occur when unreasonable compensation amounts have been paid.
The comparability data and opinion letters are also helpful to healthcare providers who need to pay amounts based on fair market value.
Opinion letters may help companies comply with FIN 48 (Accounting for Uncertainty in Income Taxes). FASB requires financial statement recognition of a tax position taken (or expected to be taken) in a tax return unless the company determines that the position would more likely than not be sustained when examined by the tax authorities. One of the most common uncertain tax positions is payment of potentially unreasonable compensation. FASB does not require an opinion letter to show that the more-likely-than-not standard has been met. However, FASB suggests that an opinion letter can be valuable support and that management should decide whether to obtain an opinion letter after evaluating all available evidence and the statutory and case law. Complex facts and the subjective nature of reasonable compensation lead some companies to protect themselves by obtaining opinion letters from independent compensation consultants (when the amounts at issue are significant).
Some opinion letters cover only a specific component of compensation such as guaranty fees. Stephen also provides opinion letters to preparers of business valuations when compensation paid to owners and/or their family members must be normalized.
Compensation opinion letters are also used by employers when hiring or promoting key employees, companies wanting to prevent the IRS from imposing section 6662 penalties, and those concerned about a potential IRS challenge over the reasonableness of compensation paid by C or S corporations to their shareholders. Stephen’s opinion letters, analyses, and reports on reasonable compensation have also been helpful in litigation involving shareholder disputes, bankruptcy, marital dissolution, and lost wages.
“The ultimate measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy.” ~ Martin Luther King, Jr.
Stephen also speaks on executive compensation issues at industry conventions, association meetings and continuing professional education seminars. His presentations have covered:
• Normalizing Owner Compensation in Business Valuations
• Compensation Paid by Non-Profit Organizations
• Reasonable Compensation at C and S Corporations
• Getting Paid What Your Services are Worth
• Golden Parachute Payments
• Recent Tax Court Cases Involving (Un)Reasonable Compensation
• Limitations on Tax Deductions for Executive Compensation at Publicly-Traded Companies
• Equity Compensation with LLCs and Partnerships
• Tax Treatment of Stock Options
• Non-Qualified Deferred Compensation Plans
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.” ~ Abraham Lincoln
Tax Assessments for Unreasonable Compensation and the 20% Penalty under Internal Revenue Code Section 6662
A company may be liable for the section 6662(a) and (b)(1) and (2) accuracy-related penalties when the IRS determines that a portion of its tax underpayment was due to either a substantial understatement of income tax or negligence. However, obtaining and relying upon an opinion letter when setting compensation amounts may help avoid penalties.
There is a "substantial understatement" of income tax for any tax year where, in the case of corporations (other than S corporations or personal holding companies), the amount of the understatement exceeds the greater of (1) 10% of the tax required to be shown on the return for the tax year or (2) $10,000. See section 6662(d)(1)(B).
Section 6662(a) and (b)(1) also impose a penalty for negligence or disregard of rules or regulations. Under section 6662(c), "negligence" includes “any failure to make a reasonable attempt to comply with the provisions of this title."
Under case law, negligence is "a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances." See Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), affirming on this issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299), affirmed, 904 F.2d 1011 (5th Cir. 1990), affirmed, 501 U.S. 868 (1991).
There is an exception to the section 6662(a) penalty when a company can demonstrate (1) reasonable cause for the underpayment and (2) that the company acted in good faith with respect to the underpayment. See section 6664(c)(1).
Regulations under section 6664(c) provide that the determination of reasonable cause and good faith "is made on a case-by-case basis, taking into account all pertinent facts and circumstances." See Reg. section 1.6664-4(b)(1).
Reliance on the advice of a compensation expert may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty. See United States v. Boyle, 469 U.S. 241, 251 (1985).
Case law provides three requirements that must have been met in order to rely on a professional adviser to avoid a section 6662(a) penalty:
(1) the adviser must have been a competent professional with sufficient expertise to justify reliance,
(2) the taxpayer must have provided necessary and accurate information to the adviser, and
(3) the taxpayer must have actually relied in good faith on the adviser's judgment.
See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affirmed, 299 F.3d 221 (3d Cir. 2002); see also Charlotte's Office Boutique, Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005), affirming 121 T.C. 89 (2003).
The penalties under Internal Revenue Code section 6662 are one of the many reasons why employers need to do some advance planning to avoid payment of unreasonable compensation.
“Leadership and learning are indispensable to each other.” ~ John F. Kennedy
Since executive compensation is a complex subject, and usually involves large amounts, some companies engage an independent compensation expert and rely on the three requirements listed above for protection against non-deductible penalties.
“There are no easy answers, but there are simple answers. We must have the courage to do what we know is morally right.” ~ Ronald Reagan
For more information about compensation opinion letters, please visit Stephen's webpage that focuses on opinion letters: CompensationOpinion.com.