The subject of “reasonable compensation” under federal tax principles can arise in many different contexts. This article highlights the most common instances and their tax implications.
Why the Interest in Reasonable Compensation?
The IRS tax guidance for “reasonable compensation” has been around a long time. For a C Corporation, it addresses whether the owner/employee, as a way of increasing the income tax deduction, was paying him or herself more compensation than was justifiable. The concern: a dividend paid to a shareholder isn’t tax deductible, therefore the IRS wants to make sure the owner/employee isn’t disproportionately allocating owner payouts to salary and bonuses, in other words, a “disguised dividend.” If the IRS prevails upon review, the business loses its tax deduction and both the C Corp and the owner would be exposed to additional tax, interest, and penalties.
For an S Corp, this can involve exactly the opposite issue for the owner/employee. W-2 compensation is subject to employment taxes (FICA and Medicare) as well as the 3.8% Medicare tax on the net investment income, but shareholder distributions are not. Hence, the goal for the owner/employee is to maintain compensation to as low a level as possible, while maximizing shareholder distributions. The less employment tax paid, the greater the net distribution to the owner. The IRS, in the event of an audit, will test payments made to the owner/employee by the S Corp to establish that they are not too heavily weighted towards shareholder distributions.
There are other situations where reasonable compensation can be an important factor, such as:
- A privately held company pays an executive a large bonus when the company is bought out by another company. Under the Sec. 280G golden parachute rules, the company must establish that the bonus was reasonable. Otherwise, there can be adverse tax effects on both the company (lost tax deduction) and the executive (20% excise tax on the bonus, and possibly other compensation).
- A company makes large contributions to an owner/employee’s deferred compensation plan. The deduction upon distribution of the deferred compensation would be disallowed if the compensation paid is deemed unreasonable.
- The owner / employee of a family-owned S Corp underpays him-or-herself, so that more profit is available to pay out in the form of a dividend to an inactive shareholder (such as a child). Where there is a failure to pay reasonable compensation to family members who actually perform services for an S Corp, the IRS can force a tax adjustment.
What does the IRS Rely Upon to Determine what “Reasonable” is?
The good news is that IRC Section 162 of the tax code provides clear guidance on what is considered “reasonable.” The IRS generally follows this guidance closely, and tax court cases have established sound precedents. Certain factors have emerged over time as being the most important to the determination of reasonableness:
- The employee’s role in the company.
- An external comparison to other businesses.
- The character and condition of the business.
- Whether there is a conflict of interest regarding the negotiation of compensation.
- Whether there is internal consistency in a company’s treatment of payments to employees.
Most important, the courts rely heavily on what is called the “independent investor” in determining whether compensation is reasonable. This test involves an analysis of the company’s return on investment vs. a peer group of similar companies within the same industry. In other words, if a company is truly a top performer, pay can be higher than average paid across comparable companies.
How to Address your Reasonable Compensation Issues
The best strategy is to work with an advisor who is experienced in compensation plans and knowledgeable of competitive market practices to structure a market-based compensation plan from the get go. Alternatively, have the current compensation plan reviewed by a professional, and adjusted as necessary before the IRS might weigh in.
When establishing that your company’s compensation is reasonable compensation, all components of total compensation paid should be considered; essential when conducting a market assessment to determine the value of an executive’s services provided to a company. The components include:
- Base salary - typically the only guaranteed cash compensation provided to employees. Base salary is the compensation an employee receives for simply performing a job, regardless of the success or failure achieved during the employment period.
- Annual incentives - at-risk cash compensation awarded on an annual basis due to a specific level of performance. Ideally, performance goals are documented in advance and incentives are provided when the designated performance levels are met or exceeded. Annual incentive criteria and rewards are frequently established at the beginning of the year; however, such documentation is less common among closely held companies. Absent documentation, closely-held companies risk blurring the lines between what is an incentive payout vs. what is a shareholder dividend.
- Long-term incentives – Long-term incentives form a considerable portion of senior executive total compensation. The primary goal is to align the goals of the executive with those of the organization's shareholders and second, to provide for meaningful retention. Of course, owner / employees may not need such an incentive, but when determining a reasonable level of market-based compensation, the value of long-term incentives should be considered. Such incentives would undoubtedly be needed to attract and retain executives who do not have a meaningful ownership stake. (However, the value of company-owned shares is not considered compensation).
- Employer-provided benefits – generally, if the owner receives the same benefits – such as qualified healthcare and a retirement plan (e.g., a 401k) - as other employees, then this portion of compensation would not be pertinent to a reasonable compensation matter.
- Perquisites – these include taxable benefits such as an automobile or auto allowances, financial planning, supplemental retirement, insurance, and club or association memberships. To the extent that these are provided to the owner/employee and not to (or to a greater level than) other employees, such items can be potentially problematic in a reasonable compensation review.
The IRS has long been suspicious of compensation paid to someone who controls the operations of the company: this usually will be an owner/employee. This is the primary reason why executive compensation in closely-held companies comes under scrutiny: the owner/employee is typically a board member, controls the board, or operates without a board. As a result, the owner/employee frequently determines his or her own compensation, which negates the possibility of an “arm's-length transaction.” The concern is that the compensation plan may be a way to save taxes on profit distributions (C Corp) or employment taxes (S Corp). The end result if the IRS prevails on review is additional taxes and penalties will be incurred, to say nothing of the time and expense incurred in dealing with an IRS audit.
Going forward, there are certain key steps an owner can take to establish defensible and “reasonable” compensation:
- Engage an independent third party to perform a competitive compensation study that examines the total compensation levels of the owner, other family members and, as desired, other selected company executives.
- Establish how these persons are compensated as compared to market pay levels for executives performing similar roles in similar companies (i.e., size, industry).
- Have compensation levels ratified by independent board members who are not plan participants.
- Document your incentive plans, addressing how bonuses are calculated and when bonuses are paid.
Completing the above steps proactively will help to mitigate tax compliance risk, and should also help you to set compensation levels for owner/employees, other shareholders and key executives in a consistent and cost effective manner that will help you meet your business objectives.
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