Factors to be Considered in Setting Compensation

Legal Cases and Statutory Factors Used to Assess the Reasonableness of Compensation

U.S. courts have established multiple factors and guidelines to assess reasonableness in compensation. This article reviews the factors and statutory criteria used to assess the reasonableness of compensation.

Determining reasonable compensation for shareholder employees in closely held companies remains a key concern for businesses, valuation professionals, and forensic accountants. U.S. courts, particularly the Tax Court, have established multiple factors and guidelines to assess reasonableness in compensation, most notably detailed in the cases of Mayson Manufacturing Co. v. Commissioner (1949) and Elliotts, Inc. v. Commissioner (1984).

The 6^th Circuit Court’s opinion in Mayson Manufacturing includes the following description of key factors:

“Such factors include the employee’s qualifications; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the salary policy of the [employer] as to all employees; and in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.”

On remand from the 9^th Circuit Court of Appeals, the Tax Court’s opinion in Elliotts included five primary factors:

1. Role of Employee: The specific role and responsibilities the employee holds within the company.
2. External Comparison: “An external comparison of the employee’s salary with those paid by similar companies for similar services.” (716 F.2d at 1246)
3. Company Character and Condition: The overall financial health and complexity of the business.
4. Conflict of Interest: Relationships that might cause companies to “disguise nondeductible corporate distributions of income as salary expenditures deductible under section 162(a)(1).” (716 F.2d at 1246) The 9^th Circuit emphasized applying the “hypothetical independent investor” perspective, asserting that if compensation reduces profits so severely that remaining profits “do not represent a reasonable return on the shareholder’s equity, an independent shareholder would probably not approve of the compensation arrangement.” (716 F.2d at 1247)
5. Internal Consistency: Salaries and “bonuses that have not been awarded under a structural, formal, consistently applied program generally are suspect,” as well as those that are “tracking either the percentage of the recipient’s stock holdings … or some type of tax benefit.” Conversely, “a reasonable, longstanding, consistently applied compensation plan is evidence that the compensation paid … was reasonable.” (716 F.2d at 1247)

While Mayson Manufacturing offers a broader framework, Elliotts places special weight on the independent investor test. Many courts continue to evaluate compensation by considering the return remaining for hypothetical outside investors after all compensation has been recorded.

Courts have also examined compensation adjustments for specific factors such as a personal guarantee of corporate loans or leases, and for amounts earned but deferred in prior years.

However, federal and state laws also identify specific factors that are not to be considered when determining compensation amounts for any employee. Under federal law, allowing one of the following factors to influence an employee’s compensation amount may be discriminatory:

Sex/Gender	Race	Genetic Information
Pregnancy	Color	Age (for individuals age 40 and over)
Religion	National Origin	Disability

Many states, including California, also have regulations which prohibit discrimination. For example, California’s employment regulations (Section 1197.5) specifically state that an employee may not be paid less than employees “of the opposite sex” or “of another race or ethnicity for substantially similar work” when “viewed as a composite of skill, effort, and responsibility, and performed under similar working conditions, except where the employer demonstrates:

1) The wage differential is based upon one or more of the following factors:

a) A seniority system.
b) A merit system.
c) A system that measures earnings by quantity or quality of production.
d) A bona fide factor other than race or ethnicity, such as education, training, or experience. This factor shall apply only if the employer demonstrates that the factor is not based on or derived from a race- or ethnicity-based differential in compensation, is job related with respect to the position in question, and is consistent with a business necessity. For purposes of this subparagraph, “business necessity” means an overriding legitimate business purpose such that the factor relied upon effectively fulfills the business purpose it is supposed to serve. This defense shall not apply if the employee demonstrates that an alternative business practice exists that would serve the same business purpose without producing the wage differential.”

Determining compensation amounts involves judgment calls that must be handled very carefully. Similar considerations could apply to changes in titles, job assignments, and promotions.

Mike Gregory, NSA, MBA, ASA, CVA, a compensation consultant and former IRS official, adds, “I think it would be a good idea for each employer to assess the reasons behind each compensation decision carefully. And keep good records in personnel files to document those decisions. This is a strong recommendation for IRS and other purposes.”

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This article is provided for informational purposes only and does not constitute legal advice. The authors are not offering any opinions in this article as each situation depends upon its own facts and jurisdiction. Employers can seek legal advice to ensure that their compensation, benefits, and promotions are non-discriminatory.

Stephen Kirkland, CPA, CMC, CFF, is a compensation consultant and expert witness at Atlantic Executive Consulting, LLC. He serves as an expert witness in cases involving potentially unreasonable compensation.

Mr. Kirkland may be contacted at (803) 724-1414 or through ReasonableComp.biz, at Stephen.Kirkland@AECG.biz.

William Phelps is a current intern at FVLS Consultancy and a student at Western Washington University pursuing a Bachelor of Arts in Accounting. He is preparing to sit for the CPA exam and plans to pursue a Master of Professional Accounting. FVLS Consultancy can be reached at info@experts.com.