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What Is a "Reasonable" Amount of Compensation?

One of the prime audit risks for business owners and high-level managers revolves around the concept of "reasonable compensation." The IRS may challenge the setup if you are paid too much or too little for the job you are doing. This is particularly true in the case of S corporation owners.

Reason: As the owner-employee of the S corporation, you are entitled to receive a salary. Those wages are subject to payroll taxes-even if the business is losing money. The IRS may investigate situations where the owner is not paid a salary commensurate with the work being performed-or any salary at all, for that matter.

How can you tell what is a reasonable amount of compensation? It's not easy. This issue has come up time and time again in the courts. However, the following five factors may be applied to a particular situation.

1. The employee's role in the company.

2. A comparison of the compensation paid to the employee with the amounts typically paid to employees of other companies in similar situations.

3. The character and condition of the company.

4. Whether a conflict of interest exists that might permit the company to disguise dividends as deductible compensation.

5. Whether the compensation was paid under a structured, formal and consistent program.

There is no one factor that is overly decisive. The courts have looked at the situation in its totality to make a determination.

Note: In the past, some C corporation owners would opt to be paid excessive compensation amounts. As a result, the corporation could fully deduct the compensation as a business expense, as opposed to paying out amounts as nondeductible dividends. However, now that dividends are generally taxed under favorable long-term capital gain rates-a tax benefit to the recipient-this occurrence is not as common.

In either event, compensation amounts may be challenged by the IRS. You can protect yourself by keeping up-to-date corporate minutes, even if your company is small. Make sure that the minutes spell out who is being paid for what, when and why. At the very least, have the minutes checked by a professional. This precaution may be well worth it if the IRS ever comes calling.

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	[ return to list ] What Is a "Reasonable" Amount of Compensation? One of the prime audit risks for business owners and high-level managers revolves around the concept of "reasonable compensation." The IRS may challenge the setup if you are paid too much or too little for the job you are doing. This is particularly true in the case of S corporation owners. Reason: As the owner-employee of the S corporation, you are entitled to receive a salary. Those wages are subject to payroll taxes-even if the business is losing money. The IRS may investigate situations where the owner is not paid a salary commensurate with the work being performed-or any salary at all, for that matter. How can you tell what is a reasonable amount of compensation? It's not easy. This issue has come up time and time again in the courts. However, the following five factors may be applied to a particular situation. 1. The employee's role in the company. 2. A comparison of the compensation paid to the employee with the amounts typically paid to employees of other companies in similar situations. 3. The character and condition of the company. 4. Whether a conflict of interest exists that might permit the company to disguise dividends as deductible compensation. 5. Whether the compensation was paid under a structured, formal and consistent program. There is no one factor that is overly decisive. The courts have looked at the situation in its totality to make a determination. Note: In the past, some C corporation owners would opt to be paid excessive compensation amounts. As a result, the corporation could fully deduct the compensation as a business expense, as opposed to paying out amounts as nondeductible dividends. However, now that dividends are generally taxed under favorable long-term capital gain rates-a tax benefit to the recipient-this occurrence is not as common. In either event, compensation amounts may be challenged by the IRS. You can protect yourself by keeping up-to-date corporate minutes, even if your company is small. Make sure that the minutes spell out who is being paid for what, when and why. At the very least, have the minutes checked by a professional. This precaution may be well worth it if the IRS ever comes calling. [ return to list ]
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