The law has always favored the term “reasonable.” For example, the law affords protection against a negligence lawsuit if a person can demonstrate he or she acted as a reasonable person would have under similar circumstances. Moreover, federal tax law provides that a taxpayer may generally avoid federal tax penalties if the taxpayer had “reasonable cause” for a failure to comply with the Internal Revenue Code (the “Code”).
But, what is “reasonable”? For those who prefer bright-line rules, you will not like the answer. What is reasonable is often in the eye of the beholder, i.e., the decision maker. Stated differently, what is reasonable is difficult to ascertain in many cases because what is reasonable to one person may not necessarily be reasonable to another.
Given these ambiguities, it is no surprise that taxpayers and the IRS have historically quibbled over a corporation’s “reasonable allowance” for salary and other compensation. Because of the nature of subchapter C of the Code (applicable to C corporations), there is almost always a natural incentive to reduce the dual level of taxes at the corporate and individual level through paying higher compensation. However, in many instances, corporations also legitimately want to pay their employees, particularly hard-to-replace executives, competitive salaries and bonuses for hard work. This Insight discusses the reasonableness requirement for deduction of compensation under Section 162(a)(1) of the Code.