Source: https://www.cohnreznick.com/insights/newsletters/irs-provides-guidance-on-reasonableness-of-compensation
Timestamp: 2017-08-19 22:16:13
Document Index: 250532106

Matched Legal Cases: ['§162', '§162', '§174', '§174', '§174', '§174', '§162', '§ 174', '§ 162']

IRS Provides Guidance on Reasonableness of Compensation | CohnReznick
IRS Provides Guidance on Reasonableness of Compensation
The IRS has provided guidance, in the form of Field Attorney Advice memo #20154501F, as to the reasonableness of compensation under IRC §§162 and 174(a). These statutes limit a corporation’s deduction for salaries or other compensation to a “reasonable allowance for salaries or other compensation for personal services actually rendered.”
IRC §162 states that reasonable and true compensation is based exclusively on the amounts that would ordinarily be paid for “like services” by “like enterprises” under “like circumstances.” The circumstances to be considered are those that exist at the date when a contract for services was made instead of those existing at the date when a contract is called into question.
Several factors are relevant in determining the reasonableness of compensation and no single factor is decisive. Case law, i.e., Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (1987), has provided an extensive list of factors to be considered. These include:
The nature, extent and scope of the employee’s work
A comparison of salaries paid with gross income and net income
The prevailing general economic conditions
A comparison of salaries with distributions to stockholders
The prevailing rates of compensation for comparable positions in comparable concerns
The salary policy of the taxpayer as to all employees
The amount of compensation paid to the particular employee in previous years
Reasonableness under IRC §174(a)
IRC Section 174(a) provides that research or experimental expenditures paid or incurred during the taxable year in connection with a taxpayer’s trade or business may be deducted currently rather than capitalized. Section §174(e) states that the requirements of §174 will only apply to research expenditures that are reasonable under the circumstances.
The Congressional intent for the reasonableness requirement for §174 was to have it “parallel the reasonable allowance requirement for salaries and other compensation under §162(a).” As such, the amounts supposedly paid for research may be re-characterized as disguised dividends, gifts, loans, or other similar payments. Congress did not intend for the reasonableness requirement to be used to question whether or not research activities were, in and of themselves, of a reasonable nature or type.
Generally, the amount of expenditure for research or experimental activities is reasonable if the amount would ordinarily be paid for similar activities by similar enterprises under similar circumstances. A taxpayer may not claim an amount of an employee’s salary representing research expenses as qualified research expenses when the value of the research services performed by the employee is worth less than the amount paid to the employee for the research services.
This case addresses salaries in the context of § 174 and § 162. However, if a taxpayer were calculating a research and development tax credit, it is possible that the IRS might attempt to apply the above reasoning to reduce not only the amount of a taxpayer’s deduction, but also the amount of the taxpayer’s qualified research expenditures – which would result in a reduction to the taxpayer’s research and development tax credit. Taxpayers taking the R&D tax credit should not only document the wages (and activities associated with the wages) that go into their qualified research expenditures, but should also consider the above factors supporting when a salary will be considered reasonable by the IRS.