What Is the Reasonableness Standard in Business and Tax?

The reasonableness standard is a flexible benchmark used in law and business to evaluate conduct. It assesses whether an individual’s or a company’s actions were appropriate by comparing them to what a prudent party would have done under similar circumstances. Its application is broad, influencing everything from contract disputes to regulatory oversight. Rather than focusing solely on the outcome, the standard emphasizes the diligence and rationale behind a decision at the time it was made. This approach fosters accountability and encourages fair dealing by establishing a shared expectation of sensible conduct.

The Objective “Reasonable Person”

At the core of the reasonableness standard is the hypothetical “reasonable person,” a legal fiction used to create a consistent benchmark for behavior. The test is objective, meaning it is not tailored to an individual’s specific mindset or personal beliefs. It asks what a person of ordinary prudence would have done, not what the specific person involved thought was appropriate.

This objective test is fundamental to ensuring fairness and predictability. By applying a uniform standard, courts and agencies can avoid the inequitable outcomes that would result from a subjective evaluation, where each person’s actions would be judged by their own personal standards. The objective standard focuses on external, observable conduct measured against a consistent ideal.

The reasonable person is not an average person but an idealized, prudent individual who exercises ordinary care and caution. This standard also adapts to the circumstances. For instance, a professional like a surgeon or accountant is judged not by the standard of a layperson but by that of a reasonable professional in their specific field, possessing the same skills and knowledge.

Application in Business and Corporate Governance

In the corporate world, the reasonableness standard is embodied in the business judgment rule. This legal principle creates a presumption that corporate directors, in making business decisions, have acted on an informed basis, in good faith, and with the honest belief that their actions were in the best interests of the company. As long as these conditions are met, courts will generally not second-guess the board’s decisions.

The protection of the business judgment rule is not absolute; it can be overcome if a plaintiff demonstrates that the board’s decision involved fraud, a conflict of interest, or was so irrational as to be outside the bounds of reasonable business judgment. The rule requires directors to exercise the care that an ordinarily prudent person in a similar position would use, which involves making a reasonable inquiry into the matter at hand.

Consider a board that approves a major acquisition after conducting thorough due diligence, including reviewing financial analyses and consulting with legal experts. If the acquired company subsequently underperforms, the directors are likely protected by the business judgment rule. A court would recognize that the decision-making process was reasonable at the time, even if the outcome was poor.

This judicial deference is grounded in the recognition that business is inherently risky and that directors, not judges, are best equipped to make complex operational decisions. By insulating directors from liability for decisions made with reasonable care, the rule encourages them to take calculated risks and pursue strategies that can lead to growth.

Application in Federal Taxation

The reasonableness standard is a concept in federal taxation, particularly for business deductions. The Internal Revenue Service (IRS) applies this standard to scrutinize expenses and ensure they are legitimate business costs rather than disguised distributions of profit or personal expenditures. This is most common when evaluating owner-employee compensation and the deductibility of general business expenses.

Owner-Employee Compensation

For closely held corporations, both C-corporations and S-corporations, the IRS scrutinizes compensation paid to individuals who are both owners and employees. In a C-corporation, the incentive may be to pay an unreasonably high salary to an owner-employee. This is because the salary is a deductible expense that reduces the corporation’s taxable income, thereby avoiding the double taxation that applies to corporate profits paid out as dividends. If the IRS deems the compensation excessive, it can reclassify the unreasonable portion as a non-deductible dividend.

Conversely, in an S-corporation, where profits pass through to the shareholders’ personal tax returns, the incentive can be to pay an unreasonably low salary. Owners might prefer to take their money out as distributions rather than salary, because distributions are not subject to payroll taxes. The IRS can challenge this practice and reclassify a portion of the distributions as wages, subjecting them to back payroll taxes, interest, and penalties.

General Business Expenses

Beyond compensation, the reasonableness standard is also inherent in the broader rule for deducting “ordinary and necessary” business expenses under Internal Revenue Code Section 162. An expense is “ordinary” if it is common in the taxpayer’s trade or business, and “necessary” if it is helpful and appropriate. An expenditure could be both ordinary and necessary but still be disallowed if the amount is unreasonable, such as a lavish or extravagant dinner with a client.

Factors for Determining Reasonableness

When regulatory bodies or courts assess whether an action or an amount is reasonable, they analyze a variety of factors based on the specific facts and circumstances of the case. This multi-factor approach is particularly evident when the IRS evaluates the reasonableness of compensation paid to an owner-employee. The analysis aims to determine what a hypothetical independent investor would be willing to pay for similar services in a similar enterprise.

Several factors are reviewed to determine if compensation is reasonable:

• The employee’s qualifications, including their training, experience, and skills.
• The nature, extent, and scope of the employee’s work, considering their duties and responsibilities.
• A comparison between the compensation in question and amounts paid to non-shareholder employees or to similar positions in comparable companies.
• The financial condition of the company, including its gross and net income and overall profitability.
• The company’s compensation policy for all employees and whether it is consistently applied.
• The history of dividend payments for a C-corporation, as a lack of dividends coupled with high salaries may suggest that compensation is a disguised dividend.

For general business expenses, the determination of reasonableness also depends on the context. Factors include common practices within the industry and the specific situation surrounding the expense. For example, the cost of business travel or meals is evaluated based on what is considered normal and appropriate for that type of business and the location. An expense that might be reasonable for a large corporation could be deemed unreasonable for a small business.