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IRS Provides Guidance on Reasonableness of Compensation


This article was distributed as part of CohnReznick's National Tax Update - December 2015 newsletter.


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 employee’s qualifications
  • The nature, extent and scope of the employee’s work
  • The size and complexities of the business
  • 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.

What Does CohnReznick Think?
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. 


For more information, please contact Richard Shevak, Director, at or 862-245-5029.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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