Do You Pay Employees “Reasonable” Compensation?

In general, employee compensation, such as wages and salaries, is taxable to workers and deductible by their employers. However, the IRS sometimes challenges employer deductions if it considers compensation, generally to owners and executives, to be "unreasonable" in its amount. This could lead to legal contests. So your organization needs to carefully evaluate the compensation you pay and make sure it qualifies as reasonable.

businessman holding a piece of paper with a dollar sign on it in front of his face

Big Tax Difference

Many employers, particularly C corporations, generally want what they pay owner-employees to be considered compensation because they can deduct it. On the other hand, dividends, typically paid to highly compensated employees, aren't deductible. They effectively make for a second level of taxation on corporate income. So some employers may choose to maximize tax benefits by aggressively increasing compensation (and reducing dividend payments).

The opposite can be true for entities such as S corporations. Income and losses usually pass through to S corporation owners and aren't subject to payroll tax. Thus, these owners generally prefer to receive distributions. Accordingly, reasonable compensation issues may arise when S corporation owners arrange to receive little or no salary.

Typically, when the IRS challenges C corporation compensation as excessive, the difference between what an employer pays and what the IRS considers a reasonable amount attributable to services actually rendered can't be deducted. Of course, companies can contest IRS determinations. But this involves legal expense and time — and the outcome isn't guaranteed.

No Bright-Line Test

There's no definitive bright-line test for determining reasonable compensation. However, courts have traditionally cited several factors, including:

It's also important to consider whether the employer and employee are dealing on an arm's-length basis, and whether the employee has guaranteed the employer's debts.

Following are three cases that highlight some of the issues involved in compensation challenges:

Case 1: The CEO and owner of a construction company (C corporation) led his company through some tough times and turned it into a profitable enterprise. When the business recorded large profits in 2015 and 2016 due primarily to the owner's personal efforts and contacts, it paid him a bonus of $5 million each year, on top of his six-figure salary. The IRS claimed this was excessive.

The U.S. Tax Court relied heavily on expert witnesses to make its determination. It ultimately decided that reasonable amounts for the bonuses were $1.36 million in 2015 and $3.68 million in 2016, respectively (Hood, TC Memo 2022-15, 3/2/22).

Case 2: The wife and two sons of a retired business owner controlled a large concrete contracting business (C corporation), with more than 200 employees. Annual revenue grew dramatically after the two sons assumed control of daily operations. Faced with the possibility of supply chain disruptions due to a cement shortage, the two sons started a separate enterprise. This enabled the concrete contracting business to prosper when competitors were suffering.

The company deducted over $4 million in 2003 and over $7 million in 2004 paid to the sons. After examining the traditional factors, the Tax Court concluded that the compensation paid to the sons was reasonable under the circumstances (H. W. Johnson, Inc., TC Memo 2016-95, 5/11/16).

Case 3: A CPA and owner and sole employee of an S corporation contracted to work exclusively for another firm in which he was a 25% shareholder. He was paid $24,000 in wages in 2002 and 2003. But he also received $200,000 in dividends in 2002 and $175,000 in dividends in 2003. When the case went to trial, the IRS's expert witness established the fair market value of a CPA's accounting services at that time to be approximately $91,000 per year. The expert relied on several compensation surveys and studies to help form this opinion.

In its analysis of the case, the Eighth Circuit Court of Appeals determined that an annual salary of $91,000 would have been a reasonable compensation for the CPA's services. Accordingly, it sided with the IRS and upheld tax deficiencies, penalties and interest totaling more than $23,000 (David E. Watson P.C., 2/21/12).

Guard Against Challenges

As these cases illustrate, employers can come out on the losing end when they go up against the IRS in compensation disputes. So it's generally better to guard against an IRS challenge. Find out what comparable companies are paying their top employees and keep good records of job responsibilities, salary history and compensation discussions in board meetings. Also consider tying executive compensation to company performance. Your professional advisors can provide additional guidance.

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