Reasonable compensation is quickly becoming an issue again. For closely held corporations, in the case of S Corporations the IRS often argues that compensation for owner employees is set too low so that it can collect employment taxes on deemed salaries while in the case of C Corporations the IRS argues that compensation may set be too high so that the corporate payroll deduction becomes a now non-deducted deemed dividend, thus allowing it to be double taxed (on the corporate return as well as the impact on owner employee’s personal return). Compensation scrutiny in C corporations will likely continue in 2013 and beyond. The fact that the first $25,000 of corporate taxable income is taxed at 15% and the next $50,000 is taxed at 25% is increasingly attractive when the top individual tax rate has climbed to 39.6% and even more so in states with high top personal income tax rates (California is 13.3%).
A Current Case Yields Telling Results
A March, 2013 case involved K&K Veterinary Supply, Inc., a large, profitable, closely held business was run by a husband, his wife, his daughter, and his brother. For the two years at issue the corporation had sales of $66 million and $60 million; gross profit of $9,700,000 (both years); and taxable income of $128,000 and $42,000. The corporation paid the husband a $30,000 dividend each year. Compensation can be deducted only to the extent that it’s reasonable. Any unreasonable portion is nondeductible and, if paid to a shareholder, may be taxed as if it were a dividend. Interesting twists and turns aside, all but $13,929 of the the husband’s combined compensation for the two years of $1,727,957 was deemed reasonable. Reasonable compensation determined for the others did not fare nearly as well for a variety of potentially avoidable reasons. The mixed results demonstrate that owners of closely held corporations can largely overcome scrutiny and also highlights some paths to prevailing.
How Much Compensation is “Reasonable”?
While there’s no simple formula, the IRS tries to determine what similar companies would pay for comparable services and under like circumstances. Factors taken into account can include:
- the employee’s duties;
- the amount of time required to perform those duties;
- the employee’s ability and accomplishments;
- the complexities of the business;
- the gross and net income of the business;
- the employee’s compensation history; and
- the corporation’s salary policy for all its employees.
Protect Your Compensation Decisions with Appropriate Documentation
Take concrete steps to make it more likely that the compensation you receive will be considered “reasonable” and therefore deductible by your C Corporation, such as:
- Use the board of directors minutes to contemporaneously document reasons for the amount of compensation paid. For example, if compensation is being increased in the current year to make up for earlier years in which it was too low, make sure the minutes reflect this. (Hopefully, the minutes for those earlier years will reflect that the compensation paid in those years was at a reduced rate.)
- Paying compensation in direct proportion to the stock owned by the corporation’s shareholders can look like a disguised dividend under scrutiny by the IRS. Beware of this.
- Keep compensation in line with what similar businesses are paying their executives (gather and keep evidence you can get of what others are paying such as salary offers to your executives from comparable companies).
- If the business is profitable, be sure to pay at least some dividends. This avoids giving a false impression that the corporation is trying to pay out all of its profits as compensation.
The list is not exhaustive, but it points out that planning your compensation strategy now can save you many head-aches and much money later.