Reasonable compensation is a topic of interest to both the Internal Revenue Service and the shareholder-employees of S corporations and C corporations.
A C corporation’s tax liability is less when compensation to the owner-employee(s) is higher and earnings are lower, effectively reducing the potential for dividends and a double level of taxation. Since S corporations are subject only to a single level of taxation, S corporation owner-employees reduce their tax liabilities when compensation is lower and earnings are higher (thus reducing employment taxes). Accordingly, the reasonableness of compensation is of interest to the IRS.
About five years ago, the IRS created an audit project aimed at attorneys who were owner-employees of S corporations. The project determined that many attorneys were not receiving what the IRS deemed to be reasonable compensation. For example, one attorney had a salary of $30,000 and distributions for the year of nearly $400,000. The IRS reclassified much of the distributions as wages and levied additional payroll taxes, penalties and interest.
The IRS contends that, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
Defining Reasonable Compensation
So what is reasonable compensation? The IRS does not provide a specific definition of reasonable compensation; it is determined on a case-by-case basis. While the subjective nature of reasonable compensation has resulted in countless battles between the IRS and corporate shareholders, those shareholder-employees who are able to provide support for their salaries are more likely to prevail. Some factors that the IRS considers when looking at the issue of reasonable compensation for an individual include:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history and effort devoted to the business
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key personnel
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Tax courts have also recognized that higher compensation is justified for individuals under the multiple hats theory, which essentially recognizes that certain owner-employees have more than one role in the company and provide a higher value.
In terms of actual dollar amounts, the IRS and courts have used third-party compensation studies to establish a reasonable compensation level. One such tool is Economic Research Institute’s (“ERI”) Executive Compensation Assessor, a leading salary survey tool and one that is also used by the IRS itself in determining reasonable salary levels. Schneider Downs Advisory Services, using this tool, has performed compensation studies for clients for a number of purposes.
As the saying goes, an ounce of prevention is worth a pound of cure. Consider the following action items:
- Discuss reasonable compensations issues with your tax advisor.
- Document: Put it in writing, before it is paid and preferably at the beginning of the year. (The IRS has argued that bonuses and other compensation paid to shareholder-employees at the end of the year, after profits have been determined, are distributions of earnings designed to avoid taxation.)
- Pay for performance: Tax courts have also ruled favorably with taxpayers whose compensation amounts were set by independent compensation committees (or minority shareholders) and were documented in employment agreements, board minutes and corporate resolutions.
- Get a market-based study: Consider getting a market-based study completed using ERI’s Salary Assessor or other third-party source.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.