Compensation: Reasonable vs. Unreasonable

Challenges to “reasonable” compensation are among the most common and most complex issues raised in IRS audits of closely-held businesses and tax-exempt organizations. As a business owner, HR professional, or other key management personnel, it is critical to understand how to evaluate whether compensation is reasonable vs. unreasonable.

Ordinary and necessary expenses, including reasonable salaries or other executive compensation for services rendered, are permitted deductions under IRC 162(a)(1) of the Federal Income Tax Law. A corporation may deduct from gross income compensation for executives, directors, managers, and trustees amounts that are reasonable and are paid purely for services. Amounts that are excessive (unreasonable) compensation may be re-classified as dividends; dividends are not corporate expenses. But, they are income to the recipient.

For privately-owned C corporations, re-classing compensation as dividends has an unfavorable tax consequence. Dividends are effectively taxed twice – first to the corporation since they are not expensed and then to the shareholder-employee as income. So, when determining whether compensation is unreasonable for your key employees, consider the following factors:

  1. How much is paid by other companies for similar services in the same industry?
  2. How much would be paid to an employee if the business was owned by an unrelated investor? Would there be enough earnings left to satisfy an investor?
  3. What are the employee’s hours, special skills, reputation, years of experience and education?
  4. Were there new clients brought to the company, increases in profitability, key relationships and other accomplishments?
  5. What are the employer-provided benefits?
  6. Is a year-end bonus awarded?

The reasonableness of the total compensation package for shareholder-employees should be carefully documented in order to avoid potential adverse tax consequences.

Often S corporation shareholders are tempted to keep their compensation low because compensation paid to S corporation shareholders is subject to payroll taxes but profit distributions are not. Decreasing shareholder compensation and increasing profit distributions minimizes payroll taxes. Federal and state tax agencies 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.

Compensation levels paid by not-for-profit organizations to their key employees are now closely examined by the Internal Revenue Service. Under Internal Revenue Code Section 4958, the IRS can impose a 25% excise tax on over-paid employees (or independent contractors) and a 10% excise tax on the organization managers who permitted unreasonable amounts to be paid. Loans to officers, directors, donors, and family members should be discouraged because they could be viewed as disguised compensation.

To avoid compensation issues often raised during an IRS audit, pay for performance and keep well-documented records. If you have any concerns or need further guidance to ensure your business or organization is meeting those requirements, speak to your accountant to evaluate your current policies.Feel free to contact BSSF if you have questions by calling 717.761.7171 (Camp Hill office), or 717.581.1040 (Lancaster office).