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Paying reasonable compensation can potentially have positive and negative tax consequences for a company and its shareholders. There is no simple formula that produces what reasonable compensation should be in a given circumstance. It is not defined by statutes, but by case law based on the facts and circumstances in each case. This makes determining what reasonable compensation is difficult, especially when there can be multiple parties with varied interests. Depending on the entity, motivation, and perspective, there can be multiple facets to arriving at what constitutes “reasonable compensation”.

S Corporation

S Corporations are frequently associated with reasonable compensation issues. There are two ways a shareholder can take money from their S Corporation: (1) wages and/or (2) distributions. The most tax efficient way for a shareholder to obtain money from the S Corporation is through distributions. By taking a distribution rather than wages, the corporation and shareholder do not pay employment taxes on the amount paid to the shareholder.

By contrast, wages are deducted by the S Corporation as an expense and are income to the shareholder. Payroll taxes are paid on the wages, which typically amount to 15.3% (not including unemployment taxes). Given that it is typically more costly to take payments from the S Corporation as wages, owners have a tax incentive to keep their wages as low as possible and take money out of the S Corporation as distributions.

The IRS is aware of the gamesmanship that can be played with reasonable compensation and has made a point to let S Corporations know that they monitor the practice. The IRS can challenge the wages paid as reasonable compensation and could reclassify some or all the distributions as wages. The IRS brings this to the attention of S Corporation shareholders, by specifically stating in its notice of S Corporation acceptance:

When a shareholder-employee of an S Corporation provides services to the S Corporation, reasonable compensation generally needs to be paid. Tax practitioners and subchapter S shareholders need to be aware that Revenue Ruling 74-44 states that the IRS will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services. The IRS may also re-characterize distributions other than dividends distributions as salary. This position has been supported in several recent court decisions.  

C Corporation

C corporations are the opposite of S Corporations. There are two ways to get money into the hands of a shareholder of a C Corporation: (1) wages and/or (2) dividends. The most tax advantageous way for a shareholder/owner to take money out of the C Corporation is through wages. Dividends are taxed at a lower individual rate, but the downside is the same money was already taxed as ordinary income at the corporate level (double taxation). Wages are an expense at the corporate level and income at the individual level, only being taxed once.

Example:

Shareholder A owns 100% of the stock in C Corporation Alpha. Shareholder A is in a 28% tax bracket individually while Corporation Alpha is in a 35% bracket. Instead of Shareholder A taking dividend distributions from Corporation Alpha and paying 35% tax at the corporate level and another 15% at the individual level (for a total of 50% tax), the shareholder could pay the money as additional wages and pay 28% (plus payroll taxes).

The reasonable compensation issue that can arise is paying too much in wages and lowering the dividends to save taxes. As a shareholder in a C Corporation, there is an expectation of a return on an investment. The IRS could argue that the return on the equity investment was not reasonable because too much compensation was paid. To solve this problem, the IRS would recharacterize wages as dividends.

Nonprofit Organizations

Nonprofit organizations have to be aware of reasonable compensation rules as well. Under Reg. 53.4958, 501(c)(3) and 501(c)(4) organizations must limit “disqualified persons and organization managers” to reasonable compensation. Amounts in excess of reasonable compensation constitute “excess benefit transactions” that may trigger additional excise taxes. Disqualified persons include:

  • Any persons who was, at any time during the five-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.
  • A family member of the above.
  • A 35% controlled entity by person(s) above.

Organization managers include:

  • Voting members of an organization;
  • Named officers – i.e. president, CEO, COO, treasurer, CFO; and
  • Others determined on a facts and circumstances basis – founder, substantial contributors, persons receiving compensation based on revenue from activities that the person controls, and person having or sharing significant control of the organization’s operating budget or activities.

There is a two-tiered excise tax on up to 200% of the excess benefit received by the disqualified person or manager. The excise tax holds a joint and several liability which means that anyone who is deemed to have received an excess benefit payment is held liable for the entire amount, not just their pro-rata share of the excess benefit.

If the organization is subject to an IRS audit, the burden of proof is on the tax-exempt organization to prove that the compensation was reasonable. There are safe harbor provisions which shift the burden to the IRS to prove the compensation is unreasonable. The three-step process is:

  • An independent authorized body without conflicts of interest approves the compensation arrangement in advance.
  • An authorized body obtains and relies on appropriate data prior to making determination – such as a compensation consultant’s data.
  • An authorized body concurrently and adequately documents the basis for making the determination of compensation.

Minority Shareholders

An often overlooked aspect of the reasonable compensation debate is the affect it has on the minority shareholders. If unreasonable compensation is being paid to the majority shareholder who works for the company, then the company’s profits are being understated. This would reduce the return the minority shareholders would be receiving on their investment. One way to combat this is to agree to have an independent third party determine what the majority’s shareholder compensation should be based on compiled executive compensation reports.

Factors in Determining Reasonable Compensation

How much compensation is reasonable? Unfortunately there is no magic formula that determines what reasonable compensation is but rather it is determined based on facts and circumstances. The factors that help determine what is considered reasonable compensation are:

  • Employees qualifications;
  • Nature, extent, and scope of the work performed;
  • The size and complexities of the business;
  • A comparison of salaries paid with gross income and net income;
  • The prevailing general economic conditions;
  • Comparison of salaries with distributions to shareholders;
  • The prevailing rates of compensation for comparable positions;
  • The salary policy of the employer as to all of its employees; and
  • The amount of compensation paid to the particular employee in previous years.

A couple ways to help determine and document reasonable compensation include:

  • Review salary surveys, especially those produced by industry groups that the company may belong to.
  • Hire an outside consultant or firm to help determine what is reasonable.
  • Document the performance criteria required for the job and the salary.

Besides the factors listed above, an additional test that was defined by the Seventh Circuit in the Exacto Spring case is the “independent investor” test. This test looks at whether an independent investor would be satisfied with the return on equity after taking into account the compensation paid to employees of the entity – particularly when the employee and the equity holder are the same person. The purpose of the test is to demonstrate that the higher the (risk adjusted) rate of return for the equity holder, the greater the salary that management can command and still fall within the bounds of reasonableness. Thus, otherwise seemingly exorbitant compensation may still be reasonable when management outperforms and delivers the high rate of return investors expect given the risk of the investment.

In most recently contested cases, courts have held that the compensation factors must be viewed through the “lens” of a hypothetical, independent investor, thus taking into account the investor test, appropriate rates of return, and many of the other factors listed above. It’s also important that companies approach compensation with an understanding of the IRS’ perspective, so that compensation can be substantiated by the above determining factors should it ever be challenged. Selden Fox has a qualified tax team that can provide an analysis of what constitutes “reasonable compensation” for your organization or situation and address any questions or issues you may have.

Nathan Sharp, MST, CPA

Nathan Sharp works with a variety of firm clients, including individuals, family businesses, business owners, and various corporations. He earned his BS in accountancy, his master’s in accounting science, and his MST from Northern Illinois University.