The Reasonable Compensation Rule
32 Pages Posted: 17 Mar 2000 Last revised: 14 Apr 2011
Date Written: November 1, 1999
This article examines the curious approach taken by courts to a long-standing precept of federal tax law, which declares that a company may deduct no more than "reasonable" compensation paid its employees. Straightforward on its face, this principle has been applied in a way that bears slight resemblance to the rule's literal content: Although the requirement as usually cited would authorize universal government regulation of employee pay (and therefore by its terms ought to be of interest, for example, for the current vigorous public debate surrounding executive compensation levels), in fact the rule has been used only to ensure that small, closely held corporations not disguise a nondeductible payment (such as a dividend) as deductible "compensation." The rule would thus be more accurately known as the "genuine compensation" requirement. More interesting than this result itself (which the article demonstrates is in fact required by tax policy and legislative history) is the process used - apparently unconsciously - by courts to achieve that result. While expressly denying any such purpose, courts have effectively interpreted the words of the rule in ways that are inconsistent with normal usage, but that tend to produce acceptable outcomes. The reasonable compensation requirement thus serves as a case study in the mutable, result-driven process of judicial interpretation of even the simplest and most familiar rules.
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