(Reprinted from Benefits & Compensation Solutions magazine)
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 Therefore, funds withdrawn from a C corporation as dividends are effectively taxed twice – to the corporation and the employee.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.
