The Multi-Factor Approach

Beginning with Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949), the courts have developed various factors to consider in determining whether compensation amounts were reasonable.  Some of the key factors are:

·       The employee’s qualifications, including education and training,

·       The nature, extent and scope of the employee’s duties,

·       The amount of compensation paid for similar services by similar businesses

·       The ratio of compensation to gross revenue and to net profits (before salaries and federal income tax)

·       Whether compensation was set by independent directors

·       Correlation between employee’s compensation and his/her stockholdings

·       The corporation’s history of paying or not paying dividends

·       Prevailing economic conditions

·       Whether payments were needed as an inducement to keep the employee at the employer

·       The financial condition of the company after payment of compensation

·       Scarcity of qualified employees

·       Discretionary bonus paid at end of year

One court listed a total of 21 factors.  See Foos v. Commissioner, 41 T.C.M. (CCH) 863, 878-89 (1981).

Several of the above factors do not directly address the reasonableness of the compensation amount.  For example, the correlation between an employee’s compensation and his/her stock-holdings does not directly speak to the amount of pay.  In addition, the corporation’s dividend history does not determine whether the compensation amount was reasonable.  Instead, these factors may help determine the company’s intent when the payments were made.  Was a payment intended to be compensation for services rendered or was it intended to be a distribution of profit?  If year-end bonus payments are in the same ratio as stock holdings, this factor may suggest that the intent was the sharing of profit.

Cases suggest that the factors listed below may indicate that a payment was compensation.

·       Long hours worked

·       Uniqueness of skills/contribution

·       Success in turning the company around

·       Above average growth and/or profitability

·       Extensive experience of the employee

·       High productivity and effectiveness of employee

·       Bonus arrangements/formula entered into prior to becoming a stockholder

·       Employee offered higher salary by other employers

·       Inability of employee to control compensation levels and/or dividends

·       Salary compares favorably with that of similar employees at peer companies

·       Employee was under-compensated in previous years

·       Return on equity is high

Case law suggests that the factors listed below may indicate that a payment was a dividend.

·       Compensation amount exceeds that of peers at comparable companies

·       Lack of dividend payments in prior years

·       Inappropriate compensation formulas

·       Lack of uniqueness of employee’s skills

·       Employee spends little time on the job or works less than in previous years

·       Board of Directors/decision makers are not independent

·       Increase in salary without increase in duties

·       Bonus formulas changed because of high profits

It is important to remember that none of these factors are controlling by themselves.  They do not all carry the same weight.

Every executive and every company is different from others, and that is why many factors need to be carefully considered.  Don’t forget to consider whether the officer is multi-lingual or has other valuable communicating, selling or negotiating skills.  Expertise with technology is valuable in some industries, as is personal or professional goodwill.

Executive compensation can be a complex matter and amounts  are not determined by completing a simple checklist.  Due to the difficulties in assessing these factors, expert witnesses are commonly used in conferences with the IRS Appeals Office and at Tax Court to help determine whether unreasonable compensation was paid.