26 CFR 1.162-7 provides that among the ordinary and necessary expenses paid or incurred in carrying on any trade or business is a reasonable allowance for salaries or other compensation for personal services actually rendered,which may be allowed as a deduction.  Nevertheless, the Internal Revenue Service (IRS) has systematically interpreted the “reasonable allowance” provision to apply only to closely held corporations, effectively concluding that a publicly held corporation can deduct an unlimited amount of executive compensation.

Pursuant to 26 CFR 1.162-8, in the case of ostensible payments by corporations, if such payments correspond or bear a close relationship to stock holdings and are found to be a distribution of earnings or profits, the excessive payments will be treated as a dividend.  It further provides that in the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in the gross income of the recipient.  The income tax liability of a recipient of an amount excessively paid as compensation, but not allowed to be deducted as such by the payor, will depend upon the circumstances of each case.

However, there are many debates on the IRS’s misapplication of Section 162(1)(a) and to render such compensation nondeductible since the IRS allows publicly traded businesses to deduct an unlimited amount of executive compensation for corporate tax purposes.  In contrast, IRS frequently applies Section 162(1)(a) to limit corporate deductions for executive compensation paid by closely held corporations.