By: John S. Morlu II, CPA
For C corporation owners, determining reasonable compensation is critical for avoiding additional tax liabilities. The IRS pays close attention to the compensation paid to shareholder-employees to ensure it aligns with the services rendered. If the compensation is deemed excessive, the IRS may reclassify some or all of it as dividends. This reclassification could lead to the loss of tax deductions for the corporation, as well as additional taxes, interest, and penalties.
Understanding the nuances of reasonable compensation is essential for both C and S corporations, but the strategies and risks differ significantly between the two.
Key Differences Between C Corporations and S Corporations
The primary tax avoidance strategies for C corporations and S corporations are nearly opposite:
- S Corporations aim to reduce shareholder wages to minimize employment taxes. By keeping wages low, more income is taxed as business profits rather than as salaries, which are subject to employment taxes.
- C Corporations attempt to reduce net income by increasing shareholder compensation. The goal here is to avoid the “double tax” effect, where corporate income is taxed at the entity level and dividends are taxed again at the individual shareholder level.
For C corporations, the IRS focuses on whether shareholder compensation reflects true wages for services provided or whether the compensation is essentially a disguised dividend. The investigation often involves examining whether the compensation aligns with ownership percentages or pretax profitability—common indicators of dividends rather than wages.
Importance of Established Compensation Policies
Well-documented and consistently applied compensation policies can significantly lower the risk of an IRS challenge. These policies should ensure that shareholder-employee compensation is justifiable based on the work performed and comparable to industry standards.
Bonuses and Perks:
- Bonuses can include considerations of profitability, but a pattern of issuing bonuses simply to eliminate taxable corporate income can raise red flags. For instance, paying a bonus just large enough to reduce corporate tax liability to zero is often scrutinized as an attempt to disguise dividends.
- Bonuses and other benefits should be extended fairly to all employees in similar roles, not exclusively to shareholders or their family members.
- Bonuses that align directly with ownership percentages are problematic, as they closely resemble dividend payments rather than performance-based compensation.
Adjustments for Reduced Workloads:
If a shareholder-employee reduces their working hours or involvement in the business—such as in cases where responsibilities are transitioning to a younger generation—their compensation should be adjusted accordingly. Paying a shareholder-employee a salary disproportionate to their actual contributions can trigger IRS scrutiny.
Guiding Legal Framework:
Section 162(a)(1) of the Internal Revenue Code allows businesses to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The key phrase here is “personal services actually rendered.” Compensation must align with the services provided and be reasonable compared to what nonowner employees in similar roles are paid.
Dividend-Paying History:
C corporations that consistently generate profits should consider paying dividends to their shareholders. Regular dividend payments help distinguish returns on investment from payments for services. Failure to pay dividends while awarding high shareholder compensation can be seen as an attempt to avoid taxes.
Analyzing Reasonable Compensation
Evaluating whether compensation is reasonable involves a mix of data-driven and holistic analysis. Courts have developed several methods to assess reasonable compensation, including factor analysis and the independent investor test.
Five-Factor Analysis:
The Ninth Circuit Court, in Elliotts, Inc. v. Commissioner (1983), identified five key factors to consider:
1. Employee’s Role in the Company: This includes qualifications, job responsibilities, and the time and effort devoted to the business.
2. Comparison to Industry Standards: Compensation is compared to what similar companies pay for comparable roles.
3. Company Characteristics: The size, type of business, and economic conditions are considered. For example, a startup may pay less than an established firm in the same industry.
4. Potential Conflicts of Interest: A major shareholder who sets their own salary may face scrutiny if there’s evidence of self-dealing.
5. Consistency Across Employees: Shareholder-employee compensation should align with how other employees in similar roles are treated.
Independent Investor Test:
This approach evaluates compensation by considering how much return an independent equity investor would expect from the business. If compensation is so high that it significantly reduces the return on equity, it could indicate unreasonable pay.
The independent investor test is particularly relevant for C corporations, where dividends are expected as part of shareholder returns. In cases like Exacto Spring Corp. v. Commissioner (1999) and Menard v. Commissioner (2009), the Seventh Circuit relied heavily on this method.
Using Market Data to Substantiate Compensation
To support claims of reasonable compensation, businesses can rely on market data. Useful sources include:
- U.S. Department of Labor, Bureau of Labor Statistics: Offers detailed compensation data by industry and job type.
- Trade Associations: Provide salary benchmarks specific to certain industries.
- Consulting Firms: Offer expert compensation studies tailored to niche markets.
- Subscription Databases: Provide real-time compensation data for a wide range of industries and job roles.
The IRS has its own set of resources and job aids to analyze compensation, including salary surveys and case law.
Relevant Legal Cases
Several court cases provide useful insights into methodologies for determining reasonable compensation:
- Elliotts, Inc. v. Commissioner (1983)
- Exacto Spring Corp. v. Commissioner (1999)
- Menard v. Commissioner (2009)
- Watson v. United States of America (2012)
These cases emphasize the importance of aligning compensation with actual services rendered and ensuring that shareholder compensation does not disguise dividends.
Summary: Best Practices for Reasonable Compensation
The IRS has the authority to challenge compensation it deems unreasonable, particularly in closely held corporations. To avoid such challenges, businesses should:
1. Document and consistently apply compensation policies.
2. Base compensation on market data and industry standards.
3. Adjust compensation to reflect actual services rendered.
4. Avoid patterns of issuing bonuses solely to reduce taxable corporate income.
5. Pay dividends regularly to distinguish returns on investment from wages.
By following these practices, businesses can reduce the risk of IRS scrutiny and ensure their compensation policies align with legal and tax requirements.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
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