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How does the IRS evaluate whether deductions are reasonable?

A new ruling by the U.S. Tax Court might be of particular interest to small business owners.

The dispute between the IRS and the business at issue arose over the amount of deductions the company claimed on its tax return for the wages of its two highest-ranking employees. The catch: The employees were the two sons of the company’s owners, and their compensation was $4 and $7.3 million for a two-year period, respectively.

Section 162 of the Internal Revenue Code allows a business to claim a deduction for reasonable compensation paid to its employees. In this case, however, IRS officials challenged the amount of wages as unreasonable, perhaps prompted by the familial relationship between the owners and employees. Yet as our tax law firm has learned, reasonableness is not a quantitative benchmark. Rather, this legal standard is contextual, set by the practices in the particular industry in question.

In this case, the Tax Court examined a variety of factors regarding the company and the work duties and responsibilities of the sons. The Tax Court noted that each brother had supervised over 100 employees, worked an average of 10 to 12 hours in a five or six-day work week, and were regarded in the industry as being hands-on and responsive in their management style. The company’s revenue also greatly increased under the sons’ management, reaching $38 million during the final year at issue. Given this context, the Tax Court concluded that the compensation was reasonable and upheld the deduction claimed by the company.

This story underscores the importance of factual context when responding to tax disputes. Our law firm is thoroughly familiar with the facts and legal strategy needed to substantiate potentially controversial tax positions. Check out our firm’s website to learn more about our Connecticut tax law practice.

Source: Accounting Today, “Tax Court Finds Compensation Paid to Sons of Company Founders Was Reasonable,” Roger Russell, Nov. 23, 2016

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