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What is Reasonable Compensation

So, What’s Reasonable Compensation Anyway?

By Sue Bosevich

Ever wonder what an adequate wage is for an owner of a small business? The answer is not as easy as looking it up in a book or in the classified section of the newspaper. The determination as to whether an individual’s compensation is reasonable is based on the specific facts and circumstances surrounding the payments. It involves looking at all aspects of the business and the owner’s role – much like what is considered in business valuations. Tax problems can surface if the compensation is too high, too low, or not payment purely for services.

A corporation is allowed a deduction for compensation only if the amount paid is reasonable. “Reasonable” compensation becomes more questionable when it involves a shareholder/employee who is personally performing the very services from which the compensation is earned.

What Factors Constitute Reasonableness? 

There is no rigid set of rules for measuring the reasonableness of compensation and no definition of “reasonableness” exists. The regs provide only that reasonable compensation is an amount paid for like services by a like enterprise under like circumstances. Court cases have shown, however, that an individual’s compensation is reasonable based on the specific facts and circumstances surrounding the payments.

The factors to be considered in establishing that compensation paid to a shareholder-employee of an S corporation is reasonable are the same as those that apply to a C corporation. These factors include:

1. The prevailing compensation rates and packages of similarly situated employees in the corporation’s industry.

2. The shareholder-employee’s qualifications and abilities. These qualifications and abilities should be documented in the personnel file.

3. The degree to which the shareholder-employee contributes to the success of the business. This should be documented in the personnel file.

4. The relationship between the shareholder’s stock ownership and the amount of compensation paid to each shareholder. The corporation should avoid compensating shareholder-employees in proportion to their stock ownership.

5. Whether the shareholder-employee was adequately compensated in prior years. Inadequate compensation is common in initial years when funds are typically reinvested to promote growth. Thus, the shareholder-employee can make up for the prior inadequate compensation in future years. Compensation paid currently for past services should be documented in a corporate resolution that also states why the employee’s past compensation was inadequate.

6. The overall size and complexity of its business operations.

7. The timing of the compensation (i.e., is it paid only after profits for the years can be determined, or are wages set early in the year before the amount of actual profits is known)

8. The ratio of compensation paid to other factors such as the net profits of the company.

A more comprehensive list of factors, titled “Factors Indicating Employee-Shareholder Reasonable Compensation” which can be used to determine the reasonableness of compensation.

The determination of reasonableness involves more than just an analysis of the amount of cash paid to each employee. Although the IRS usually places more emphasis on cash payments, in certain cases, the amount of noncash compensation also receives IRS scrutiny, especially when the noncash compensation represents a substantial benefit to the employee. The use of noncash compensation (also known as “fringe benefits”) requires careful tax planning. In a C corporation, the cost of a fringe benefit generally is deductible at the corporate level, and the employee who receives the benefit excludes the value from income. In an S corporation, however, fringe benefits paid on behalf of a greater-than-2% shareholder are subject to special rules and are usually treated as additional wages to the shareholder, subject to payroll taxes.

C Corporation considerations:

Wages paid to a shareholder as an employee of a corporation are deductible by the corporation and taxable to the shareholder. Wages are not double-taxed, as is the case with dividend distributions (dividends are not deductible by a C corporation and are taxable to the shareholder). This creates an incentive for a shareholder in a C corporation to take as high a wage as possible in order to minimize taxes on corporate earnings. If compensation is determined to be excessive, the excess over the amount considered reasonable may be treated as “constructive” dividends instead of deductible wages.

The IRS may challenge the deductibility of year-end bonuses, especially when such bonuses appear to be distributions of corporate profits rather than merited rewards for performance during the year.

S Corporations considerations:

The primary concern with S Corporations is not excessive compensation, but inadequate compensation. If an S corporation is not paying a “reasonable” salary to a shareholder who provides services to the corporation, distributions to that shareholder may be recharacterized as wages subject to payroll taxes.

Having distributions reclassified as wages can be expensive. The corporation must pay the FICA and FUTA on the wages, and may be required to pay income tax withholding of 28% of the wages. The corporation will be subject to the failure to file penalty, the failure to deposit penalty (if payroll tax returns were not filed), and conceivably, the negligence penalty.

Substantial tax advantages can be gained by S corporations using compensation to achieve certain objectives. As a result, a significant portion of IRS activity in the S corporation area is directly or indirectly related to the reasonableness issue. Those areas are:

  •  Reallocation of S corporation income among family members
  •  Minimizing salaries to reduce payroll taxes
  •  Using compensation to minimize built-in gains and passive investment taxation
  •  Reducing salaries to change character of shareholder’s income

Look for an expanded discussion of these four areas in the May issue of the Bottom Line – Online.

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