Contingent compensation may be a discretionary bonus or an amount to be determined by a written formula. Either way, it should meet the same standards of reasonableness and compensatory intent as traditional salary compensation.
To determine whether an amount is reasonable, consider the facts and circumstances which existed at the time the bonus was declared or when the formula or contingent arrangement was adopted. Treasury Regulation § 1.162-7(b)(2) says:
“The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.”
Bonuses for executives are sometimes based on a percentage of EBITDA or some variation of income. Neither the regulations nor the Tax Court have established specific guidelines as to the percentage of EBITDA that may be paid out as reasonable compensation. In various published cases, amounts as high as 65% have been considered to be reasonable and amounts as low as 20% have been determined to be unreasonable compensation. The differences are key factors such as the size of the companies, their industries, and the nature and extent of the duties performed by the shareholder-employees.
A contingent compensation formula does not necessarily have to be applied to other (non-owner) employees in order for it to produce reasonable compensation for the CEO.
One factor to be considered is the contingent pay plan’s approval by other directors and/or shareholders. In Allen L. Davis, et al v. Commissioner, T.C. Memo 2011-286, the Tax Court allowed a closely-held payday lender to deduct $37 million when the former CEO exercised a stock option that had been granted with the consent of other shareholders.
Clearly, there is much to consider for any employer who wants to motivate its executives to provide their best services, and also to avoid payment of unreasonable compensation.