Executive Compensation: What's Reasonable?

Safe passage through the minefield of deductibility.

June 2009
by Philip Garrett Panitz/Journal of Accountancy

When a corporate client seeks words of wisdom regarding tax planning, most CPAs go through the litany of suggestions related to acceleration of deductions and deferral of income. Yet one of the biggest and potentially most dangerous tax issues facing corporations is the compensation paid to the top executives and whether the IRS will allow the company to deduct the full compensation paid.

Public Companies and Performance-Based Pay

In the publicly traded company arena, the IRS has signaled it will follow a literal reading of the requirements for performance-based compensation deductible under IRC § 162(m) for amounts over $1 million. Private Letter Ruling 200804004 and Revenue Ruling 2008-13 interpreted IRC § 162(m) as disallowing a deduction even if the employee’s contract contains performance-based criteria if the employee can also receive the compensation for employment that is terminated without cause or for voluntary retirement. Contract provisions that allow compensation to be paid upon the employee’s death or disability or a change of control or ownership of the corporation will not cause performance-based compensation to cease to be regarded as such.

Otherwise, if the salary is based on objective performance criteria but ultimately could be paid via any other provision of the employment contract, the performance criteria is superfluous and the deduction is lost. It is irrelevant to the IRS whether in hindsight the payments were made because the objective performance criteria were met or whether termination without cause or a retirement led to the payment.

This article has been excerpted from the Journal of Accountancy. Read the full article here.