The reasonableness of shareholder and employee compensation is an important though often controversial income tax consideration for closely held corporations such as either a C corporation or an S corporation.
When excessive amounts of compensation and benefits are provided to an individual, the IRS will treat the excess as dividends. This can result in double taxation. Corporate taxable income is taxed once at the corporate level and again at the shareholder level when that income is paid out as dividends.
When overly generous salaries and benefits are given, the corporation should be prepared for a fight with the IRS which will argue that the compensation amounts exceed what’s ordinarily paid by similar companies to workers who supply similar services. This is referred to as the reasonable compensation test.
Cases before the US Tax Court abound. Sometimes the court rules that millions of dollars was deductible as reasonable compensation, and in others orders that salaries be lowered. When making its decisions, the Tax Court uses an analysis, which includes:
- The employee’s role in the company.
- The employee’s qualifications.
- The nature, extent, and scope of the employee’s work.
- An external comparison with other companies.
- The size and complexity of the business.
- The character and condition of the company.
- Potential conflicts of interest.
- Internal consistency of compensation.
- Whether there is a conflict of interest regarding the negotiation of compensation.
- A comparison of salaries paid with the gross income and net income of the business.
- A comparison of salaries with distributions (or dividends) to stockholders.
- The prevailing rates of compensation for comparable positions.
- The prevailing general economic conditions.
Rules Vary
In an S corporation, the concern is about not compensating the shareholder reasonably. In a C corporation, the concern is about overcompensating a shareholder. In a closely held C corporation, the corporation pays income tax on profits gained. If we are to pay the sole shareholder all of the profits as salary, the C corporation would not pay income taxes. Reduction in the salary of a sole shareholder doesn’t necessarily mean that the corporation or the shareholder, for that matter, will pay astronomical amounts in taxes. With one type of business, you are trying to get the salaries of the shareholders up, while in another type of business, you are trying to get the salaries down. One thing is certain: We need to know the rules of the particular situation that we are in, for the sake of our clients.
Higher Audit Enforcement Ahead
When the economy changed and tax revenues declined, Congress and the US Treasury Department put pressure on the IRS to generate additional tax revenues. The results? The IRS issued its opinion regarding higher audit enforcement.
One of the areas of high enforcement is officer compensation for shareholders of Subchapter S corporations – and this topic is on the IRS hot list. Unfortunately the code and regulations are vague and don’t clearly define reasonable compensation for shareholders. The consequences of misinterpretation or abuse of the law can be quite costly if a business has an audit for reasonable officer compensation.
The law requires corporate officers (shareholders) who perform services for the corporation and receive payments, or are entitled to receive payments, to have their compensation considered as wages. Courts have consistently held that officers and shareholders of S corporations who provide more than minor services to their corporation and receive, or are entitled to receive compensation, are considered employees, and the payment is considered taxable for federal employment tax purposes.
Because there are no specific guidelines for reasonable officer compensation outlined in the Internal Revenue Code or the Treasury regulations, audits are reviewed on a case-by-case basis. Nine factors the courts considered in providing rulings for reasonable compensation cases include:
- Duties and responsibilities of the shareholder.
- The time and effort the shareholder devotes to the business.
- Training and experience of the shareholder.
- What comparable businesses in the industry pay for similar services.
- Dividend history.
- Payments provided to non-shareholder employees.
- Compensation agreements.
- The timing and manner of paying bonuses to key people in the corporation.
- Any formula used to determine compensation.
In addition, the IRS will consider fringe benefits paid to shareholders as compensation in a reasonable officer compensation audit. For example, health insurance premiums paid on behalf of more than 2% of shareholders of S corporations are considered fringe benefits that are reportable as wages for federal income tax withholding purposes on the shareholders’ W-2, but are not subject to Social Security and Medicare (FICA) and federal unemployment taxes. There are other fringe benefits that can be considered income but health insurance is the hottest one currently for Congress and the IRS.
Clients must maintain accurate and detailed recordkeeping to use in justifying why the officer compensation paid was reasonable. Due to the current economic and political landscape, we should expect to see a substantial increase in reasonable compensation audits. This topic is, and will continue to be, on the forefront of the IRS hot audit list. We highly recommend that clients review their policies, procedures, and recordkeeping, and identify what is reasonable for their industry and the services they provide to their corporation. What was reasonable several years ago may not be reasonable today.
CONTACT US: C-Corps often try to over claim wages to shareholder-employees, and try to “zero-out” profits. This “zero-out” tax planning strategy may only be used to the extent that the compensation is reasonable. In the real world, the reasonable compensation test is often not easy to apply to closely held companies. There are often business founders who made big personal sacrifices over the years, were grossly underpaid while having been the driving force behind their company’s growth and profitability. Sometimes large salaries are just “catch up” payments from decades of taking low salaries due to cash-flow restraints. Nevertheless, clients must be prepared for a potential reasonable officer compensation audit that may come knocking on their door. As the economic and political environment changes, Fuoco Group can help clients adapt and make changes to officer compensation, find new avenues for tax savings, and maintain better records. If you operate a profitable C corporation, passing the reasonable compensation test may be the key to avoiding double taxation. Your Fuoco Group tax advisor can assist you.