Defending an Employee's Worth – A Primer on Reasonable Compensation
An executive’s compensation and fringe benefits are a key component of successful business strategy and planning. Business owners without the luxury of compensation committees or the expertise to analyze the theory, benefits or pitfalls of under or over compensation that is not sustainable under IRS scrutiny, may be handed a tough pill to swallow. The IRS allows taxpayers a deduction for expenses that are incurred to the extent they are ordinary and necessary under Section 162 of the Internal Revenue Code. i.e., for a “reasonable allowance for salaries or other compensation for personal services actually rendered.” Therein lies the dilemma, what is reasonable?
As a pre-emptive measure to avoid a dispute with the IRS, but of course with no guarantees, a more scientific approach to the valuation of employee compensation should be performed. One method and the most common that is utilized is the market approach. The “market approach” considers other employees situated in the same industry with similar job descriptions, by using surveys and SEC filings alongside other factors in deciding if the compensation is fair relative to industry standards. Under the “income approach,” the financial performance of the company is considered alongside compensation. This method relies heavily on the independent investor test. Would an independent investor be satisfied with their return on capital? Of course this is directly tied to the amount of compensation being paid which directly affects the bottom line.
The method most often used by the courts to decide what constitutes reasonable is determined under the “amount” and “purpose” tests, with a greater emphasis on the amount. The courts use a number of factors to determine if the compensation is in alignment with what is reasonable, which includes:
- Employee’s role in the company.
- External salary comparison.
- Financial condition of the company.
- Whether a conflict of interest exists.
- If the company is consistent with their payments to employees.
The exploitation of the compensation deduction to achieve a desired tax result (clearly not objective) exists at various entity levels, which has led to the IRS to scrutinize these deductions carefully. For example, a family owned or closely held businesses should exercise caution when paying children or related parties so as to ensure that their compensation is determined without bias and the valuation is substantiated. When dealing with highly paid executives in large companies, compensation should be structured in such a way as to remove any doubt as to whether the payment is tax deductible compensation or the payment of a non-deductible dividend based on the performance of the company. In a desire to mitigate the effects of double taxation, corporations may be over-compensating their executives. Note that there are other compensation tools are available to corporations including fringe benefit and deferred compensation arrangements to achieve the same results of lowering corporate earnings without the scrutiny.
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Another prevalent issue surrounding compensation has required owner/employees of S corporations to be more aware of and plan for what the IRS or the courts may be deem to be unreasonably low compensation. By under compensating or paying no compensation at all to the owner/employee of the S corporation there is the potential for the owner /employee to lower their overall tax liability. In lieu of the compensation to be paid, the owner/employee instead pays themselves a dividend, thus avoiding the impact of Social Security and Medicare taxes. Distributions by the S corporation that result in unusually high returns on investment to the shareholder can send a signal to the IRS that the compensation paid to the shareholder/employee is too low. Another potential benefit from lowering the compensation occurs when the S corporation owner has insufficient basis to deduct pass-through losses. By lowering compensation and thereby increasing the pass through income of the entity, a corresponding increase to shareholder basis occurs that may be enough for the shareholder to deduct the otherwise un-utilized losses. The IRS is not in the dark when it comes to these techniques. Especially in cases that involve personal service type organizations the IRS’s view is that since profits are generated primarily by the personal efforts of the employees, a significant portion of the profits should be paid out in compensation rather than distributions. Suffice it to say that a tax return that is filed reflecting unusually low or no compensation at all, is probably at a higher risk of being examined by the IRS.
If in the event that the IRS does scrutinize the reasonableness of the compensation and to try to limit the deduction, effective defenses that have been utilized include:
- Part of the compensation is being paid currently for any prior years under compensation.
- The employee holds multiple job responsibilities.
- The hypothetical independent investor test was satisfied.
- The employee personally guarantees company debt.
- The employee is viewed as a “key” employee and deserves extraordinary compensation – especially in cases with an employee owner of stock since the payments must be properly allocated between services rendered (deductible) versus a dividend (not deductible).
A Tax Court memo issued in 2016 exemplifies a case where the owners of a concrete contracting business demonstrated that they were integral to the financial success of the company. They attested to the importance of their role in company growth and illustrated their steady guidance of company affairs despite a major a concrete shortage. It was these factors that enabled them to successfully argue that their compensation deserved to be significantly higher than industry benchmarks. The owners convinced the court to conclude that an independent investor would have been satisfied with their return on investment.
As a good general guideline, companies should employ the following techniques in developing and sustaining reasonable compensation levels:
- Compensation policies should be consistently applied.
- Use outside consultants and CPA’s trained in determining reasonable compensation.
- Document in corporate minutes anything utilized to justify the level of compensation.
- Utilize comparables.
- Avoid compensation as a means to erase earnings.
- Consider the value of services provided and do not set compensation levels proportionate to ownership.
- Pay based on contribution to company success.
It is without question that there is much latitude in the somewhat subjective question of what is reasonable. It appears that IRS and courts would like to remove the subjectivity and create objective standards for taxpayers to follow. However, the different methodologies that are accepted or rejected as evidenced by the numerous decisions on this subject, suggests that the determination of reasonableness varies widely by jurisdiction and even within the same jurisdiction. However, the fear of audit or a lost deduction should not outweigh the merits of preparedness and well-executed strategic tax planning to find the best solution for your company.