The Tax Court recently found that there’s indeed a limit on the tax-deductibility of wages paid to employees by the employer. 

What constitutes “reasonable” compensation for this purpose? It depends on the particular circumstances. Traditionally, the courts have relied on several key factors to make a determination if compensation is reasonable or not.

Background: It makes a big tax difference to employers if amounts are paid to highly-compensation employees as compensation or dividends. If the amount is treated as compensation, it is deductible from the employer’s taxable income. Conversely, dividends aren’t deductible, and effectively represent the second level of tax on corporate income.

As a result, some employers choose to maximize the tax benefits for amounts paid to high-ranking employees by increasing their compensation. However, if an employer simply pays an employee whatever it wants, it could get into trouble with the IRS. Typically, if the IRS challenges the amount as being excessive, the difference between the payment and a reasonable amount attributed to services actually rendered is nondeductible.

Facts of the new case: The CEO and owner of a construction firm in South Carolina shepherded his company through rough times and turned it into a profitable enterprise. At one point in his career, he secured a bid worth  $30 million of revenue with a gross profit margin above 40%, the biggest in the company’s history.

When the construction firm recorded large profits in 2015 and 2016 due primarily to the owner’s personal efforts and contacts, it paid him a bonus of $5 million each year, in addition to his six-figure salary. But the IRS thought this was excessive—even for this one-man dynamo.

The Tax Court examined the following factors to assess the reasonableness of the bonuses paid to the CEO:

• The employee’s qualifications
• The nature, extent, and scope of the employee’s work
• The size and complexities of the business
• A comparison of salary paid with gross income and net income
• The prevailing economic conditions
• A comparison of salaries with distributions to shareholders
• The prevailing rates of compensation for comparable positions in comparable concerns
• The salary policy for all employees

In reaching its conclusion, the Tax Court relied heavily on expert witnesses. It ultimately decided that reasonable amounts for the bonuses were $1.36 million in 2015 and $3.68 million in 2016, respectively.

Lesson to be learned: Prepare your clients for potential challenges to compensation deductions by the IRS. Keep detailed records spelling out the reasons for paying high salaries and bonuses.