Know the Ins and Outs of 'Reasonable Compensation'

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July 03, 2008

The IRS may object to the compensation of shareholder-employees of a corporation. If the compensation is deemed too high or too low — in other words, it is not reasonable under the circumstances — the IRS could force you to make adjustments that increase taxes. This can be particularly troublesome for:

  • S corporation owners who arrange to receive little compensation, or no compensation at all, to reduce payroll taxes.
  • C corporation owners and executives who are also shareholders and receive salaries the IRS considers too large because they will then be hit with double taxation. Why? Compensation is fully deductible if it's considered reasonable. But if a salary is deemed too large, Uncle Sam can label part of the payments as "disguised dividends," which are taxed twice.

Double taxation comes into play because when the corporation distributes profits as salaries, the firm gets a deduction for the amount. The owner or executive pays personal income tax on the money, of course, but it's only taxed once. But if the corporation pays the owner or executive a dividend, the money is taxed twice — once at the corporate level and again at the personal level.

Not surprisingly, the issue of reasonable compensation is frequently contested in the courts. Here are two examples:

Taxpayer Loser

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The shareholder employee of a family-owned corporation served as its president. The three other officers of the corporation were the president's sons. According to court documents, she voted on major corporate decisions for the waste pickup and disposal business and performed other duties, such as attending civic functions as a company representative. Nevertheless, the IRS argued that she functioned more like an outside board chairperson, rather than a chief executive, and was unreasonably overcompensated.

The Tax Court determined that her salary for the three years in question should be $98,000, $101,000 and $106,000 rather than the amounts deducted by the corporation ($860,680, $818,060 and $600,060 respectively). The company appealed the decision.

The 9th Circuit Court focused on the following factors to determine a reasonable amount of compensation for the owner-employee:

  • The employee’s role in the company.
  • A comparison of the compensation paid to the employee with the amounts typically paid to employees of other companies in similar situations.
  • The character and condition of the company.
  • Whether a conflict of interest exists that might allow the company to disguise dividends as deductible compensation.
  • Whether compensation was paid under a structured, formal and consistent plan.

Based on these five factors, the appeals court concluded compensation should be adjusted to reflect her performance as president of the company. It sent the case back to the Tax Court for "redetermination of reasonable compensation." (E.J. Harrison & Sons, CA-9, 6/7/05)

Taxpayer Winner

By documenting the reasons for corporate salaries, you may be able to fend off the IRS. In one Tax Court case, for example, a business gained some leeway because it paid a windfall amount to make up for salary shortfalls in the past.

In the case, a father and son were the owners and principal employees of a mechanical contracting business. For the year in question, the father was paid a salary of $260,000, plus standard fringe benefits. The IRS said that $65,000 of this salary represented unreasonable compensation.

But by looking at several factors, including the fact that the father had been underpaid in prior years in order to build up the company’s cash reserve, the Tax Court determined that the entire compensation amount was reasonable. (Devine Brothers, Inc., TC Memo 2003-15)

Advice: Spell out the reasons for compensation amounts in your corporate minutes. The minutes should be reviewed by a tax professional before being finalized. Cite any executive compensation or industry studies, as well as other reasons why compensation is reasonable. Work with your tax adviser to determine whether dividends should be paid (and if so, how much they should be).

Corporations must justify their salaries based on factors such as the expertise of a shareholder employee, the size of the firm and comparable industry pay.

Salary vs. Dividends: Yesterday, Today — and Tomorrow

In the past, C corporation owners often arranged to be paid relatively high compensation amounts in order to increase business deductions instead of paying out nondeductible dividends. That's because dividends used to be taxed at regular income tax rates. However, qualified dividends are currently taxed at the same favorable federal rates as long-term capital gains (the maximum rate is only 15 percent). As a result, high salaries are not necessarily preferred today.

But there is a sunset provision in the tax law. Unless Congress takes further action, dividends received after 2008 will once again be taxed at regular income tax rates, instead of the favorable capital gains rates. So shareholder employees may someday again prefer salary payments over dividends.

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