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What is Reasonable Compensation?
By Stephen D. Kirkland, CPA, CMC, CFC
The income tax laws allow corporations to deduct ordinary and necessary expenses incurred in carrying on their businesses. This includes compensation for services performed by officers and stockholders, but only if certain requirements are met.
The requirements vary depending on whether the corporation is publicly-traded or privately-owned.
Publicly-Traded
A corporation is publicly-traded if it has a class of common stock that is registered under the 1934 Securities Exchange Act.
Section 162(m) of the Internal Revenue Code limits a publicly-traded corporation’s tax deduction for compensation paid to a “covered employee” to a maximum of $1,000,000 per year. A covered employee is an individual who is the corporation’s CEO or is one of the four highest paid officers other than the CEO.
Certain types of compensation are not subject to this $1,000,000 limit and are not included in the calculation:
(1) commissions;
(2) performance goal remuneration (if approved by outside directors and shareholders and certain tests are met);
(3) contributions to qualified retirement plans;
(4) tax excludable employee welfare benefits; and
(5) certain amounts under a pre-1993 written contract.
Stock options are generally not included in compensation if they meet the requirements for performance-based compensation; however, some grants of restricted stock may not qualify for the exclusion.
Privately-Owned
A privately-owned corporation paying unreasonable compensation to a shareholder-employee is required to reclass the excess as a dividend (provided there are adequate corporate earnings and profits). This has unfavorable tax consequences, since dividends are not tax deductible. Therefore, funds withdrawn from a C corporation as dividends are effectively taxed twice – to the corporation and the employee. Compensation is taxed only once – to the employee.
Whether compensation is unreasonable depends on all the facts and circumstances. Compensation is considered to be reasonable if the same amount was paid for comparable services provided by someone other than a stockholder. A true comparable, however, is rarely available.
Also consider how much an employee would be paid if the business was owned by an unrelated investor. After payment of all compensation, are there enough earnings left in the business to satisfy this hypothetical investor?
We also weigh other factors. For example, look at the employee’s input – long hours, special skills, and years of experience and education brought to the job.
We examine the employee’s output, or the results he or she achieved. After all, pay for key employees should be performance based. Consider new clients brought to the company, increases in profitability, and similar accomplishments. Measuring one person’s accomplishments can be difficult, however, since many things are accomplished through the efforts of several people working together.
In addition to an employee's salary, employer-provided benefits should be considered in determining whether that employee's compensation is reasonable. This includes pension and welfare benefits, as well as fringe benefits such as the use of a company car. An otherwise high salary might be reasonable if the employee’s benefits are less than those typically provided to a comparable employee.
If a year-end bonus is to be awarded, the terms should be written out in advance. The bonus may be set as some percentage of the increase in pretax profits over the prior year, for example. If a bonus is awarded, a resolution should explain how and when it was earned.
Someone’s compensation for a particular year may include an amount for services performed in an earlier year. Business owners often receive reduced pay in the early years of a business, even though that may be when they work the hardest. They also may not be adequately paid during periods of rapid growth, when cash flow is tight. They are entitled to catch-up pay later.
If the employee will be temporarily underpaid, and will expect catch-up pay later, consider saying so in a written employment agreement.
Due to the potential adverse tax consequences, shareholder-employees should carefully document the reasonableness of their total compensation, explain how the amount was determined, and document the unique and valuable nature of their services.
Unlike C corporations, S corporations are tempted to keep the compensation of shareholder-employees low. This is because S corporations do not pay income tax on their profits. Instead, each shareholder pays income tax on his or her share of the S corporation’s profits each year. That means shareholders pay only one level of income tax on their compensation and on their profits. But compensation is also subject to payroll taxes and profit distributions are not. Therefore, to minimize payroll taxes, S corporations may set shareholder compensation unreasonably low and increase profit distributions. So federal and state tax authorities regularly audit S corporations to ensure they pay enough compensation. As with C corporations, documentation should be kept to show how compensation levels were set.
These compensation issues are often raised in IRS audits. To keep your guard up, pay for performance and maintain good records.
Stephen D. Kirkland, CPA, CMC, CFC is a compensation consultant and serves as an expert witness in U.S. Tax Court cases involving reasonable compensation issues.
Expert Witness Testimony
Stephen Kirkland has provided expert witness testimony in three U.S. Tax Court cases involving the reasonableness of executive compensation. One case resulted in a bench decision, one settled subsequent to Stephen’s testimony, and one resulted in a published decision (see Choate Construction Co. T.C. Memo 1997-495). Other cases settled prior to beginning of the trial.
His cases have involved companies in South Carolina (two cases), California (three cases), Florida, New York (two cases), New Jersey, Georgia (four cases), Mississippi, and Ohio.
Those cases have involved companies in the following industries:
Automobile dealerships (two cases)
Construction (six cases)
Pharmaceutical distribution
Food Importing
Pipeline / fuel distribution
Telecommunications
Technology
Healthcare
Financial services
Opinion Letters
We provide opinion letters on the reasonableness of compensation paid to executives and other key employees at hospitals and other tax-exempt organizations subject to the excess benefit transactions rules of Internal Revenue Code section 4958.
We also provide opinion letters to companies subject to FIN 48. FASB does not require an opinion letter to show that the more-likely-than-not standard has been met. However, FASB believes that an opinion letter can be valuable support and that management should decide whether to obtain an opinion letter after evaluating all available evidence and the statutory and case law.
Complex facts and the subjective nature of compensation may lead many companies to obtain tax opinion letters to protect themselves (when the amount at issue is significant).
We also provide opinion letters to preparers of business valuations, when compensation paid to owners and/or their family members must be normalized.
Excess Benefit Transactions at Tax Exempt Organizations
The Internal Revenue Service keeps a close eye on tax-exempt organizations to ensure that their exempt status is not abused. Under Internal Revenue Code section 4958, the IRS can impose a 25% excise tax on the unreasonable portion of any compensation received by a key employee. The IRS can also impose a 10% excise tax on an officer or director who permitted the excessive payment. These excise taxes are imposed upon the individuals, not on the charity.
The Code refers to this unreasonable compensation as an “excess benefit transaction” because the employee is getting a benefit (compensation) in excess of the value of services he provides in exchange.
Internal Revenue Code §4958(a) applies to payments made by organizations exempt from tax under §501(c)(3) or (4):
excess-benefit-tax-exempt.html
(1) On the disqualified person
“There is hereby imposed on each excess benefit transaction a tax equal to 25 percent of the excess benefit. The tax imposed by this paragraph shall be paid by any disqualified person…with respect to such transaction.”
(2) On the management
“…there is hereby imposed on the participation of any organization manager in the excess benefit transaction, knowing that it is such a transaction, a tax equal to 10 percent of the excess benefit, unless such participation is not willful and is due to reasonable cause. The tax…shall be paid by any organization manager who participated in the excess benefit transaction.”
Qualified Retirement Plans
Under Internal Revenue Code section 404(c), which came out of ERISA, each plan sponsor has fiduciary responsibilities to protect the interests of the participants. Among these responsibilities is an obligation to ensure that fees charged to participants’ accounts are reasonable. This includes fees charged by investment managers, auditors, attorneys, advisors, and others.
Recently, several high-profile lawsuits have been filed against sponsors, alleging that these companies allowed unreasonable fees to be charged by investment managers.
A second but related issue involves advisors who recommended certain investment managers and then benefited from revenue sharing arrangements with those investment managers.
The sponsors’ fiduciary obligations to the participants require that the sponsors have the participants’ best interests in mind.
Accounting for Uncertain Tax Positions (FIN 48)
In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertain Tax Positions (known as FIN 48).
Effective for years beginning after December 15, 2006, preparers of financial statements must recognize and measure all uncertain tax positions taken by the company. This includes estimating and disclosing the amount of the company’s potential tax assessments. Disclosure of the potential impact of such position is required, unless the company believes that their position would “more likely than not” be upheld under audit or in court. One of the issues is a potential tax assessment due to payment of unreasonable compensation.