Can Shareholders Determine Reasonable Compensation for a CEO?

Stephen D. Kirkland CPA, CMC, CFC, CFF
May 28, 2013 — 2,050 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

Can Shareholders Determine Reasonable Compensation for a CEO?

Yes, according to at least one opinion published by the United States Tax Court.

In Allen L. Davis, et al v. Commissioner of Internal Revenue, T.C. Memo2011-286, the Tax Court considered an unusual set of facts.  Mr. Davis and his two adult sons were shareholders of an extremely profitable S corporation.  When Mr. Davis exercised a stock option that he had been granted less than two years earlier, the company deducted almost $37 million of compensation expense. 

The Tax Court ruled that the amount was not unreasonable based primarily on the facts that Mr. Davis’ sons had agreed to the option grant and they had interests that were adversarial to those of their own father.  (There was strife among the family and there had been litigation amongst them.)

The ruling is distinguished because the court did not rely on the usual multi-factor approach, comparability data or the hypothetical investor test.  Instead, Judge Kroupa decided that Mr. Davis’ compensation amount must have been reasonable since the other shareholders had agreed to it when the option was granted.  The opinion states, “The granting of the Allen Option was reasonable because it was not a one-sided bargain.”  In effect, the court relied on the other shareholders to determine whether the compensation was reasonable.

In May 2013, the Eleventh Circuit affirmed the Tax Court’s decision, allowing the company to deduct the $37 million and requiring Allen Davis to report that same amount of compensation income.

For more information on determining reasonable compensation, please see www.ReasonableComp.biz

Stephen D. Kirkland CPA, CMC, CFC, CFF

Atlantic Executive Consulting Group, LLC

Stephen is a compensation, benefits and tax consultant and expert witness.