Compensation Limits and Bad Debts

Unreasonable compensation

• Compensation for services is deductible if reasonable. The Code does not define reasonable; Reg. §1.162-7(b)(3) says what would ordinarily be paid for like services by like enterprises in like circumstances. Courts look at the executive’s qualifications and role, comparable salaries, the size and success of the company, and whether the pay makes up for lean early years (Mortex, Alpha Medical).
• The whole package is judged: salary, bonus, deferred compensation, pension contributions, fringe benefits.
• The issue lives in closely held corporations, where the owner sets his own pay. If excessive pay tracks stock ownership, the IRS recharacterizes it as a constructive dividend (Reg. §1.162-8): no deduction to the corporation, still taxable to the shareholder, now at dividend rates with no payroll tax. If the “salary” is really a payment for property — the former partners who sold the business and stayed on — it goes into the basis of the property (Reg. §1.162-7(b)(1)).
• Negligence penalties are available to the IRS on top of the disallowance.
• added 2026 The mirror image is the S corporation, where the IRS argues the owner’s salary is too low. For a C corporation client the question at year-end is the reverse: is the bonus that zeroes out the corporation’s income defensible as pay, or is it a dividend wearing a W-2?

Golden parachutes — §280G and §4999

• A parachute payment is compensation to a disqualified individual — an officer, shareholder or highly compensated individual (the top 1% of employees or the top 250, whichever is smaller) who performs services — that is contingent on a change in ownership or effective control of the corporation or a substantial portion of its assets, where the present value of all such contingent payments equals or exceeds three times the individual’s base amount.
• Base amount: average annual compensation for the five tax years before the change.
• Three times is only the trigger. Once tripped, the excess parachute payment is everything over one times the base amount. The corporation gets no deduction for the excess. The recipient reports the whole payment as income and pays a nondeductible 20% excise tax on the excess.
• Exempt: reasonable compensation for services actually rendered before or after the change; payments by a corporation that could be an S corporation (small business corporation); payments by a private corporation whose agreement was approved by holders of more than 75% of the voting stock after adequate disclosure; payments to or from qualified plans, SEPs and SIMPLEs. A public company has no exemption.

The $1 million cap — §162(m)

• A publicly held corporation may not deduct more than $1 million a year of compensation paid to a covered employee. Since 2018 a publicly held corporation is any one that must register securities or file reports under the Exchange Act, and covered employees are the principal executive officer, the principal financial officer, the three other highest-paid officers, and anyone who was a covered employee in any tax year after 2016 — including after they leave and after they die.
• The 2017 act eliminated the exceptions for commissions and performance-based compensation. What remains outside the cap: contributions to qualified retirement plans; tax-free fringe benefits; amounts already disallowed under §280G; and pay under a written binding contract in effect on November 2, 2017 and not materially modified since (or February 17, 1993 for the original grandfather).
• Stock option spreads and stock appreciation rights are compensation and count toward the cap. Under pre-2018 law they escaped it if the plan stated a per-employee share maximum and the exercise price was at least the grant-date price; repricing an option consumed the share maximum a second time. That is history except for grandfathered contracts.
• Affiliated group members aggregate the pay and share the disallowance pro rata. added 2026 For tax years beginning after December 31, 2025 the aggregation is statutory and extends to the whole controlled group under §414. added 2026 For tax years beginning after December 31, 2026, the next five highest-paid employees — officers or not — are covered employees as well, without the once-covered-always-covered rule. check Final regulations on both.
• The outside-director and pre-established-performance-goal rules that fill several pages of the course (two or more outside directors on the committee, goals set within 90 days or before 25% of the period, de minimis payments to a director’s employer not exceeding the lesser of $60,000 or 5% of its gross revenue) governed the performance-based exception. They matter now only for contracts grandfathered from 2017.
• Separate $500,000 caps with no exceptions: executives of TARP-assisted financial institutions (§162(m)(5), effectively dormant) and of health insurance providers (§162(m)(6)).
• added 2026 Not in the course: tax-exempt organizations pay a 21% excise tax under §4960 on pay over $1 million and on excess parachute payments to their covered employees, and the 2025 law widened that group to all employees over the threshold for tax years beginning after 2025.
• None of this reaches a closely held corporation. For our clients the compensation question is reasonableness, above.

Bad debts — §166

• The reserve method died in 1986 (except for small banks). A bad debt is deducted when a specific debt becomes wholly or partially worthless and is charged off.
• A bona fide debt requires a debtor-creditor relationship under a valid, enforceable obligation to pay a fixed or determinable sum (Reg. §1.166-1(c)). Advances to a shareholder with no note, no interest and no repayment are not debts.
• Business bad debts — proximately related to the business — are ordinary losses, and partial worthlessness may be deducted as it is established and written off. Nonbusiness bad debts are short-term capital losses, deductible only when wholly worthless. The test is the lender’s relationship to the debt, not how the borrower used the money. (A corporation’s debts are nearly always business debts; the nonbusiness rule mostly bites the shareholder who lends personally.)
• An accrual-basis corporation deducts worthless receivables from sales, fees and rent because it already took them into income. A cash-basis corporation never reported the unpaid invoice, so there is nothing to deduct — only an actual loss of money or property.
• Worthlessness is a facts question (Reg. §1.166-2): a signed note, invoices, collection letters, and evidence the debtor cannot pay. Suing is not required if it would be futile. Bankruptcy is evidence of at least partial worthlessness; deduct when the likely recovery is known, not when the case closes.
• A deposit lost in an insolvent bank may be treated as a casualty loss by election (§165(l)).
• Recoveries (§111): a later collection of a debt written off is income to the extent the write-off produced a tax benefit. If only part was written off, collections are first applied to the balance not written off, and only the excess is income.

Study questions 27–41

• 27. Not part of compensation: unemployment benefits.
• 28. Not a defense to unreasonable compensation: the executive thinks it is reasonable.
• 29. Jack, base $300,000, parachute $1,200,000. Threshold $900,000 exceeded; excess $900,000; excise tax $180,000; the corporation deducts $300,000.
• 30. Not part of the parachute definition: payment to a “qualified” individual — it is a disqualified individual.
• 31. Base amount: average annual compensation for the five years before the change.
• 32. Not exempt from the cap: amounts under a performance goal set by management. Retirement plan contributions, 1993 contracts and tax-free fringes are exempt.
• 33. Bill, 2018, $1.5 million under a shareholder-approved performance plan: $500,000 disallowed. The exception is gone.
• 34. Jon, $2 million from Best, Ace and Good ($1,000,000 / $600,000 / $400,000): Good’s share of the $1 million disallowance is $200,000.
• 35. Paula, 15% owner of Peach (revenue $2 million), appointed to Apple’s committee for 2018; Apple paid Peach $65,000 in 2017. Not an outside director: the de minimis ceiling is the lesser of $60,000 or $100,000, and $65,000 exceeds it. Her retirement-plan benefits from Apple would not have disqualified her.
• 36. Officer with $1.5 million salary exercises 20,000 options at a $15 spread in 2018: deductible $1,000,000. (Pre-2018 the answer would have been $1,300,000, with the option gain exempt.)
• 37. Pre-2018 outside director: a payment of $60,000 for personal services to an entity with $1.3 million of revenue where the director is an employee with no ownership is within the lesser of $60,000 or 5% ($65,000).
• 38. Allowance increased $70,000; actual charge-offs $20,000 from prior-year sales and $30,000 from current: deduction $50,000.
• 39. Not needed to show worthlessness: legal action.
• 40. $18,000 billed; customer offers $12,000 ($9,000 now, $3,000 next year); then pays $9,000 instead of $3,000. Write off $6,000 in Year 2; $6,000 of income in Year 3.
• 41. Hargo deducts a $15,000 balance in Year 2; Dana pays $5,000 in Year 3: $15,000 deduction in Year 2 and $5,000 income in Year 3.

Private reference, not client advice. Notes taken from a 2019 continuing-education course (Thomson Reuters Checkpoint Learning, C Corporations — Overview of Corporate Income Tax); figures and rules brought current to 2026 in October 2026 (P.L. 119-21, Rev. Proc. 2024-40, Rev. Proc. 2025-32). Verify current-year amounts before relying on them.