Memo 2
Memorandum
To:File
From:Date:October 21, 2014
Re:Mi Amore – Reasonable Compensation Determination
Facts
Molly James and Isabelle Collins are owners of Mi Amore, a C Corp. They were audited and disallowed a deduction for compensation by over 1 million dollars. The auditor said the disallowance wasn’t based on the reasonable criterion, but rather, that the disallowed amount wasn’t intended to be compensation.
Issues
Can the IRS disallow a deduction for compensation without determination that the compensation is unreasonable?
What are the criteria that the courts use to determine whether amounts are intended to be compensation?
Conclusions
No, the IRS cannot disallow a deduction for compensation without determination that the compensation is unreasonable. The IRS must determine whether the deduction for compensation is unreasonable to disallow a deduction that was taken. They may disallow any portion of a compensation deduction determined to be unreasonable and tax it as a dividend to the recipient.
Looking to various cases, the Courts identified six factors in determining the reasonableness of compensation:
The employee’s role in the business.
Comparison of the employee’s salary with what similar companies pay for similar services.
The character and condition of the company;
Any potential conflicts of interest, mostly in the relationship between the company and the employees;
Internal consistency that how company treats the payments to the employees;
Whether an independent investor would be willing to compensate the employee for that amount.
Support
IRC §162(a)(1) provides a deduction for ordinary and necessary business expenses, containing “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Then, in order that compensation can be deductible under IRC §162, (1) the payment must be purely for services rendered, and (2) the amount of compensation must be reasonable. It is the first prong of this
To:File
From:Date:October 21, 2014
Re:Mi Amore – Reasonable Compensation Determination
Facts
Molly James and Isabelle Collins are owners of Mi Amore, a C Corp. They were audited and disallowed a deduction for compensation by over 1 million dollars. The auditor said the disallowance wasn’t based on the reasonable criterion, but rather, that the disallowed amount wasn’t intended to be compensation.
Issues
Can the IRS disallow a deduction for compensation without determination that the compensation is unreasonable?
What are the criteria that the courts use to determine whether amounts are intended to be compensation?
Conclusions
No, the IRS cannot disallow a deduction for compensation without determination that the compensation is unreasonable. The IRS must determine whether the deduction for compensation is unreasonable to disallow a deduction that was taken. They may disallow any portion of a compensation deduction determined to be unreasonable and tax it as a dividend to the recipient.
Looking to various cases, the Courts identified six factors in determining the reasonableness of compensation:
The employee’s role in the business.
Comparison of the employee’s salary with what similar companies pay for similar services.
The character and condition of the company;
Any potential conflicts of interest, mostly in the relationship between the company and the employees;
Internal consistency that how company treats the payments to the employees;
Whether an independent investor would be willing to compensate the employee for that amount.
Support
IRC §162(a)(1) provides a deduction for ordinary and necessary business expenses, containing “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Then, in order that compensation can be deductible under IRC §162, (1) the payment must be purely for services rendered, and (2) the amount of compensation must be reasonable. It is the first prong of this