What is Reasonable Compensation?
The IRS requires that reasonable compensation be paid to shareholder-employees of both C and S corporations in return for services provided; however, it does not provide a clear definition of what reasonable compensation is. Instead, the following factors in determining reasonable compensation are listed on the IRS website:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
In addition to these factors, the corporation’s source of gross receipts must also be considered. If most of the income is associated with the services of the shareholder, it is more appropriate that distributions be allocated as compensation than if the income is attributed to services of non-shareholder-employees or capital and equipment.
Although compensation may in fact be reasonable, taxpayers should consider carefully documenting each executive’s qualifications, duties, and key accomplishments. Several court cases support the authority of the IRS to reclassify wages as other forms of payment, while other cases support the opposite, making documentation crucial.
How Will an IRS Challenge Affect C Corporations?
Closely-held C corporations tend to be examined to determine if shareholder-employees have been overpaid. Since dividends are not deductible, but compensation is, the IRS may attempt to recharacterize a portion of compensation that it considers excessive as a constructive dividend. This not only results in the corporation losing its deduction for that amount, but tax, interest, and penalties on the resulting increase in income will also be assessed.
How Will an IRS Challenge Affect S Corporations?
While C corporations are often audited to determine if shareholder-employees are overpaid, S corporations are examined in an effort to detect the opposite. Since wages are subject to payroll taxes, but distributions are not, the IRS has noticed that significant tax savings can be realized by reducing the former and increasing the latter. Recent court cases have put a heavy emphasis on the use of comparability data to determine standard pay rates for certain positions. If the IRS successfully recharacterizes distributions as wages, not only will the taxpayer be subject to increased taxes, penalties, and interest, but disproportionate distributions could be created. As S corporations are generally required to make distributions on a pro rata basis, this could terminate the company’s S status.
There are steps that can be taken to minimize the risks of having the IRS deem executive compensation unreasonable. If you have any questions regarding reasonable compensation or any other tax matters, please do not hesitate to call us at 858-558-9200.