Reasonable Compensation - When is it Too Much and When is it Not Enough? (article)
In a closely held business, the lack of arm's length negotiations makes it difficult to separate the value of the services provided by owners and their families from the profits of the businesses. Depending on the entity structure, business owners may be tempted to pay themselves unreasonably high or low compensation as a means to avoid double taxation, additional income taxes or additional payroll taxes. Reasonable compensation is an issue frequently targeted by the IRS. Business owners must understand the factors that the IRS analyzes in assessing reasonable compensation and must be prepared justify compensation levels if questioned.
To be deductible, compensation not only must be an ordinary and necessary expense of carrying on a trade or business, but it must also be reasonable. Whether compensation is reasonable is a highly subjective determination based on all of the facts and circumstances and, as such, this matter is frequently challenged by the IRS when it considers compensation to be unreasonably high or unreasonably low in an attempt to avoid taxes.
In the context of a regular C corporation, the IRS may assert that a portion of the shareholder-employee's compensation is excessively high and is, in fact, a disguised dividend. The IRS may deny the compensation deduction for the excess payment and tax the payment to the employee-shareholder as a dividend, resulting in double taxation (albeit at a lower tax rate on the dividend income than on compensation). Also, subject to challenge might be payments to relatives of shareholder employees who are not actively involved in the business. Just because the compensation to a shareholder-employee of a C Corporation is high, does not necessarily mean that it is excessive.
For an example of the consequences of excessive compensation, assume a C corporation with a 34 percent marginal tax rate pays a salary to a shareholder-employee that is deemed to be excessive to the extent of $100,000. The $100,000 compensation deduction at the corporate level would be denied, resulting in $34,000 of additional corporate tax. Because of the favorable qualified dividend tax rates, the shareholder-employee would actually realize a federal income tax decrease of as much as $19,600, still a net combined tax increase of $14,400.
An S Corporation, in contrast to a C Corporation, already enjoys a single level of tax as the entity itself does not pay tax, but rather the shareholders are taxed on the income of the entity. The issue then becomes not whether the compensation is excessive, but rather, whether the compensation is too low for the services performed. If compensation is viewed to be too low and distributions are being taken by a shareholder-employee, the IRS has been very successful in recent years in re-characterizing distributions as compensation subject to FICA and FUTA taxes. It is essential to note that not all shareholders will be involved in the business and they may simply have the ownership as an investment. In that case usually there are non-shareholder employees who are actively running the business and being compensated accordingly. In addition, in start-up businesses the compensation levels may be expected to be lower in the beginning years as initial capital is being built up for start up expenses.
Unfortunately there is no bright line test as to what constitutes too much or too little compensation. Some factors to consider when evaluating shareholder-employee compensation include:
- the training and experience of the shareholder-employee;
- the shareholder-employee's specific duties and responsibilities;
- the time and effort devoted by the shareholder-employee to the business;
- what comparable businesses pay for similar services;
- whether a formula is used to determine compensation;
- whether the compensation is in proportion to ownership;
- the corporation's dividend paying history;
- the adequacy of the corporation's capitalization;
- whether the compensation was increased at the end of the year;
- whether the employment agreement is characteristic of compensation for services;
- comparisons of compensation to gross and net income; and
- the size and complexity of the business.
Proper planning in structuring defendable compensation can be accomplished by having well-defined written employment agreements, defining the scope of services in those agreements and researching compensation levels for the position and area. Courts utilize an independent investor test to determine the level of return that would satisfy a hypothetical independent investor for the company in question. This test includes detailed calculations to value the business, determine the cost of capital and calculate the return on a hypothetical valuation. If the return exceeds the deemed cost of capital, the analysis will indicate that the shareholder-employee compensation is not excessive.
Please consult your CBIZ MHM tax professional today to see what steps you should take to assure that your shareholder-employee compensation can be substantiated as reasonable if challenged by the IRS.
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