Red Flags in Reasonable Compensation

How does an IRS agent determine that an organization might have a reasonable compensation issue? We can look to the Reasonable Compensation Job Aid for IRS Valuation Professionals[1] (the “Job Aid”) for some ideas.  The Job Aid suggests steps that IRS agents may take to identify reasonable compensation issues in taxable or tax-exempt entities.  Besides salary surveys, an IRS agent may consider some of the following factors in identifying possible issues:

1. Process for Setting Compensation

IRS agents consider how compensation is set in an organization.  Is the compensation-setting process handled by a Compensation Committee or other such body that is independent from the individual(s) whose compensation is being determined?  Does the organization keep contemporaneous records documenting the process and decisions reached?  Is comparable market data considered by the decision-makers?  Are the individuals whose compensation is being set in a position to influence the process either directly or through other persons?

2. Tax Return Information

Beyond looking at an employee’s Form W-2, an IRS agent may look for other forms of compensation on an employee’s tax return, including management or consulting fees, covenants not to compete, commissions, legal and professional fees, rent or housing expenses paid, or other forms of compensation. 

3. Number of Employees at Issue

An IRS agent might also look to the organization’s tax return to identify the number of highly paid employees.  For a C-Corporation with receipts over $500,000, Schedule E attached to the Form 1120 will provide a breakdown of officers’ compensation.  (However, this does not include compensation deducted elsewhere on the return.)  For tax-exempt entities, Form 990, Part VII lists the compensation of officers, directors, trustees, key employees and other highly compensated employees and independent contractors.  Besides these forms, IRS agents look for unusually large amounts on Forms W-2 or Forms 1099. 

4. Sales Comparison

An IRS agent may also compare the total officers’ compensation as a percentage of company sales to industry averages.  The Job Aid states that a broad indicator of officers’ compensation as a percentage of sales is usually less than 10% at the 90th percentile for mid-sized or large, mature businesses.  The Job Aid recognizes, though, that differences may exist between industries.

5. Taxable Income Comparison

The Job Aid also suggests adding back the compensation of individuals in question to determine if it significantly changes taxable income.  For corporations, if most of the income is taken out of the corporation as compensation, the IRS may argue that some of the compensation is a disguised dividend.  As another broad indicator, the Job Aid cites Officers’ Compensation divided by Taxable Income (Before NOLs) should be less than 1.0 for a medium or large, mature business.  However, smaller or privately held companies may have a higher percentage of income as officers’ compensation than do larger, publicly traded firms.  Again, the Job Aid recognizes that this analysis may vary significantly between industries. 

6. Subordinates Comparison

A comparison may also be done of salaries paid at various levels within the organization.  The Job Aid states, that in many cases, the second-highest- compensated employee will have total compensation of 50% to 80% of the CEO’s total compensation.  A ratio that is significantly lower may indicate an issue.

These considerations provide a general idea of what the IRS might be looking at to identify red flags in the area of reasonable compensation.  However, red flags do not indicate that a person is being paid more than what the IRS would deem to be reasonable compensation.  There might be market conditions or additional facts and circumstances that support the compensation paid. 

Schneider Downs Business Advisory Group provides compensation studies to aid organizations in documenting their reasonable compensation processes.  Please contact Joel Rosenthal at 412-697-5387 of the Schneider Downs Business Advisory Group to discuss how we can assist you with your advisory needs.

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.

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

For more information, contact Schneider Downs or visit the Our Thoughts On blog.

[1] The Job Aid was developed by a team of IRS Valuation Professionals from the Large Business and International Division and was published on October 29, 2014.  Note that the Job Aid is not official IRS position and may not be used or cited as authority for setting any legal position.  However, it is useful for reference purposes to understand the process by which the IRS develops reasonable compensation issues.