Determining Reasonable Compensation

An elusive standard in closely held businesses

Businesses, whose employees frequently hold significant ownership interests, are particularly vulnerable to IRS attack on their compensation deductions.

A company organized as an S- or a C-corporation, reasonable compensation becomes an important concept.  Generally, on audit, the IRS will look to see if salary to owners is too high (for C-corporation owners) or too low (for S-corporation owners)

Companies structured as an unincorporated sole proprietorship, a partnership, or a LLC, reasonable compensation is not something to be concerned about.  That’s because, such business entities are generally taxed as partnerships, and the income owners or partners earn from them is subject to personal income tax and self-employment tax.

The IRS has stated on a number of occasions that owners of closely held businesses must receive wages.  As an owner-employee, one must be paid a salary, and payroll taxes on the salary.  The salary doesn’t have to be high, but it must be a “reasonable amount” according to the IRS. 

Reasonableness can be interpreted in different ways, such as basing compensation for owners on the same or similar criteria as salary for non-owners.  Factors would include prevailing market rates; the individual’s knowledge, skills, and abilities; amount of hours worked; and so on.  Salary is reasonable if a non-owner would be willing to accept the job at the proposed salary level.

It is not uncommon in private, closely held businesses such as S-corporations where owners receiving compensation is less than what his or her duties would command; thereby requiring additional compensation in order to bring the owner’s pay up to a “market level”.  In this case, such owner’s typically rely on augmenting their compensation through distributions.

In this situation, the strategy yields a savings associated with the absence of payroll taxes.  Should the IRS deem the policy as an attempt to avoid such taxes, the assessed penalties are severe.  As such, the IRS vigorously challenges compensation that is deemed to be too low as being reasonable.

For an S-corporation, distributions and other payments by a business to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.  

The following are several factors cited by the IRS in determining reasonableness of an employee’s compensation: 

• Nature of the duties.
• Background and experience required.
• Knowledge of the business.
• Size of the business.
• Contribution to the profit making of the business.
• The time working in the business.
• The economic conditions, in general, and locally.
• The relationship of ownership to compensation.
• The amount paid by similar businesses in the same area to equally qualify employees for similar service.

Working with many small to medium sized businesses, Hodges & Hart seeks to balance owner’s compensation with distributions while considering its tax implications.  In the case of business valuations, it is common practice to adjust, normalize owner’s salary to reflect reasonable compensation levels based on industry expectations and other related factors.

Hodges & Hart is available to assist with a customized analysis of how an owner’s compensation fits within the various rules and guidelines, or you can read more at IRS.gov.

This article is authored by: Brian Tanz, AVA, CBA & Director