What is reasonable compensation?
The IRS requires that a closely held business pay its owner/employee a “reasonable” level of compensation. But what is reasonable?
Should the sole owner and company president make $100,000 a year? Or should it be $250,000? What about during an economic downturn or during a less profitable year — is $50,000 a reasonable salary?
Like so much of the tax terminology used in the code, “reasonable compensation” is not defined in black and white, leaving business owners to wonder if their current salaries are enough, if they are too much, or if their compensation level could be challenged by the IRS.
Why does it matter?
Why does the IRS scrutinize compensation levels? The answer depends on the type of business entity involved. For C Corporations, the IRS wants to ensure that owners are not being paid too much and that high salaries aren’t really a disguised dividend. Since dividend payments are a reduction in equity and not a deductible expense of the company, reclassifying excess compensation as a disguised dividend prevents the company from taking a tax deduction for the salaries paid.
S Corporations contend with the opposite issue relating to reasonable compensation. Many S Corporation owners want to keep their salary as low as possible and pay themselves through equity distributions. S Corporation distributions represent income that has already been taxed and is tax-free when paid out to the owners. In addition, unlike compensation, S Corporation distributions are not subject to payroll taxes.
Determining and supporting compensation levels
Business owners are faced with the task of determining a reasonable level of compensation that will be successful if ever challenged by the IRS.
Be mindful of the following in determining compensation levels:
- The history of the company. Newly formed companies may be trying to keep cash within the company to increase working capital and to fund growth. Conversely, established companies may have history of paying dividends or making distributions
- The experience and skill level of the owner/employee. Document information that differentiates an individual such as prior key positions held, education level, leadership skills, accomplishments, industry contacts, etc.
- Ensure that compensation plans are documented and approved by other officers or shareholders
- When determining a bonus to be paid to an owner/employee, include non-shareholders in the bonus pool. Calculate the bonus based on the performance of the company, not based on ownership percentage
- Review the wages of others in similar positions for comparability
- Document loans between the owner and the company with a note that contains a reasonable interest rate. This prevents the IRS from challenging the loans and reclassifying them as compensation
The issue of reasonable compensation is complex, with no safe harbor or objective standard to follow to ensure compliance. Rather, owners and their CPAs must analyze the circumstances of each particular situation to reach a conclusion. Being aware of the issues surrounding the adequacy of compensation for both C Corporation and S Corporation shareholders will help to prevent an IRS challenge.