Taxing Unreasonable Compensation

This post comes to us from Aaron Zelinsky.

In my paper, Taxing Unreasonable Compensation: §162(a)(1) and Managerial Power, which is forthcoming in the Yale Law Journal, I argue that IRS should disallow tax deductions for unreasonable compensation paid by publicly held corporations.

Section 162(a)(1) of the Internal Revenue Code allows companies to deduct “a reasonable allowance for salaries or other compensation.” The IRS has systematically interpreted “reasonable allowance” to apply only to closely held corporations, effectively concluding any amount of compensation paid by a publicly held corporation is “reasonable.” The IRS bases this interpretation on the presumed arms-length nature of the board-CEO relationship, which sets compensation at a “reasonable” level.

I argue that, in light of the managerial power hypothesis, executives may exercise undue influence over the board in setting their compensation. Therefore, publicly traded corporations may lack the appropriate oversight and incentive infrastructure to set executive compensation reasonably. Thus, the IRS should examine the compensation of both publicly and privately held corporations.

I suggest two methods for achieving this result: first, the IRS could employ the same multi-factor test to evaluate compensation paid by publicly traded corporations as it does for the compensation paid by their privately traded brethren. Second, the IRS could assess the objective traits of the corporations CEO-board relationship to determine the propensity for management influence in the setting executive compensation.

The full paper is available for download here.

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One Comment

  1. Stephen Kirkland
    Posted Friday, March 26, 2010 at 11:30 pm | Permalink

    Executive compensation is one of the most controversial, interesting and complex issues in American business today. Everyone has an opinion on what is reasonable compensation and what is unreasonable compensation. Yet we have to look very closely and examine the facts to know what someone’s services are really worth. But if an executive at a publicly held company is over-paid, the shareholders suffer. If that excess compensation is not tax deductible by the company, do the shareholders suffer even more?