This note identifies the inequities inherent in the failure to recharacterize unreasonable compensation payments and proposes that the taxpayer be allowed to present evidence of an alternative characterization after the government determines a reasonable allowance. Part I of this note demonstrates the historical applications of section 162 supporting a purpose of challenging payments disguised as compensation with an accompanying tax advantage. It will explore the legislative history and statutory implications, as well as applications in case law. Part II explains the highly subjective character of the determination of reasonableness and explores the numerous dimensions of that judgment. Part III explains the impact of that subjective determination in the formulation of intents, i.e., the intent to compensate and the intent to make a gift. Part IV deals with the issues surrounding recharacterization as constructive dividends. Part V compares the section 162 limitation on deductible compensation to other statutory provisions limiting the deduction for compensation and distinguishes the statutory purpose of such limitations in the publicly traded setting from the section 162 limitation in the closely-held setting. Part VI integrates the findings to conclude that there is an equitable demand for recharacterization and an entitlement of the taxpayer to present evidence of an alternative characterization.
Note, Recharacterization of Unreasonable Compensation: An Equitable Mandate, 51 Clev. St. L. Rev. 301 (2004)