"Reasonable" Compensation:
A Favorite Issue For IRS Auditors

Written by: Steven J. Fromm, J.D., LL.M. (Taxation)

Overview

The general rule is that in order to be tax deductible, compensation must be a reasonable payment for services. Smaller companies, whose employees frequently hold significant ownership interests, can control how much salary is paid to them.  As a result, they are particularly vulnerable to IRS attack on their compensation deductions.

Reasonable compensation is generally defined as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. This broad definition is supplemented, for purposes of determining whether compensation is deductible as an ordinary and necessary expense, by a number of more specific factors expressed in varying forms by the IRS, and case law from the United States Tax Court and the Circuit Courts of Appeal.  Generaly, courts look to the type and extent of services provided, the financial concerns of the company, and the nature of the relationship between the employee and the employer.

The Disguised Dividend Argument: A chief concern behind the IRS's keen interest in what a company calls "compensation" is the possibility that what is being labeled compensation is in fact a constructive dividend. If employees with ownership interests are being paid excessive amounts by the company, the IRS may challenge compensation deductions on the grounds that what is being called deductible compensation is, in fact, a nondeductible dividend.

Paying Personal Expenses of Employee By the Business Entity: Another area of concern for the IRS is the payment of personal expenses of an employee that are disguised as businesses expenses. There, the business is trying to obtain a business expense deduction without the offsetting tax paid by the employee in recognizing income. Many small business owners use the business or corporate account as a second pocketbook to pay personal and non-business related expenses.  The danger is that a business and its owners can end up with the following multiple tax exposure after an IRS audit:

Remember that if such adjustment occurs this additional income had no income or social security withholding taken on such additional income which may result in underpayment and other tax penalties and interest.

Factors Used To Determine Reasonable Compensation

The factors most often examined by the IRS in deciding whether payments are reasonable compensation for services or are, instead, non-dedcutible disguised dividend payments, include:

1. The salary history of the individual employee
2. Compensation paid by comparable employers to comparable employees
3. The salary history of other employees of the company
4. Special employee expertise or efforts
5. Year-end payments
6. Independent inactive investor analysis
7. Deferred compensation plan contributions
8. Independence of the board of directors
9. Viewpoint of a hypothetical investor contemplating purchase of the company as to whether such potential investor would be willing to pay the compensation.

Failure to pass the reasonable compensation test will result in the company's loss of all or part of its deduction. Analysis and examination of a company's compensation deductions in light of the relevant listed factors can provide the company with the assurance that the compensation it pays will be treated as reasonable -- and may in the process prevent the loss of its deductions.

Payments Proportional to Stock Ownership:

In the course of performing the compensation-dividend analysis, watch out for compensation that is proportional to stock ownership. While not always indicators that payments are distributions of dividends instead of compensation for services, their presence does suggest the possibility. Compensation plans should not be keyed to ownership interests. Drafting the correct legal documents in this area is key to minimize this exposure.

Contingent and Incentive Plans:

Contingent and incentive arrangements are also scrutinized by the IRS. The courts have frequently ruled that a shareholder has a built-in interest in seeing that the company is successful and rewarding him for increasing the value of his own property is inappropriate. Similar to the reasonable compensation test, however, this rule is not hard and fast. Accordingly, the rules followed in each jurisdiction will control.

Special Rules For Publicly Traded Corporations: In the case of publicly held corporations, a separate $1 million dollar per person cap is also placed on deductible compensation paid to the CEO and each of the four other highest-paid officers identified for SEC purposes. There are various exceptions to this rule.  For example,  certain types of compensation, including performance-based compensation approved by outside directors, are not included in the $1 million limitation.

The S Corporation: IRS Makes The Polar Opposite Argument

The opposite side of the reasonable compensation coin is present in the case of some S corporations. The tax strategy is for shareholders to report more income on their Form 1120S as K-1 pass through income and less via salary. By characterizing compensation payments as dividends, the owners of these corporations seek to reduce social security employment taxes due on amounts paid to them by their companies.  This saves employment taxes for both the shareholder and the matching social security to be paid by the entity. 

The IRS is wise to this strategy and has increased their auditing of such S corporations.  In these cases, the IRS attempts to recharacterize dividends as salary if the amounts were, in fact, paid to the shareholders for services rendered to the corporation.  So, ironcially the IRS will be on the opposite side of the argument by saying that the salary paid to the S shareholders was unreasonably low. 

Conclusion

Determining whether a shareholder-employee's compensation is reasonable depends upon many variables, such as the contributions that employee makes to your business, the compensation levels within your industry, and whether an independent investor in your company would accept the employee's compensation as reasonable.  Courts give different weighting to each of these factors depending on where your corporation operates. 

The tax exposure in this area of reasonable compensation is often missed or little understood.  Prudence would dictate a more customized analysis of how your particular compensation package fits into the various rules and guidelines. Further examination of your practices not only may help your business better sustain its compensation deductions as reasonable but may also help take advantage of other compensation arrangements, fring benefits and other tax savings opportunities.

Copyright © 2012 - Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved.

If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.