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Reasonable Compensation: It’s Complicated

May 22, 2017

The IRS is on the lookout for organizations that pay their top employees excessively. Read on for five factors your compensation policies should meet to be considered “appropriate.”

Did you know that the IRS monitors how much owners and other members of your organization’s management team are paid? Here’s when compensation issues are likely to arise and how to support your deductions for top employees.

Monitoring Compensation

The Reasonable Compensation: Job Aid for IRS Valuation Professionals publication provides insight into this controversial subject from the perspective of an IRS examiner. Compensation deductions may be questioned when:

  • C corporations overpay owners (in lieu of paying dividends) to avoid double taxation,
  • Pass-through entities underpay owners to minimize payroll taxes, or
  • Family businesses pay excessive salaries to family members (in lieu of making monetary gifts).

The IRS is also on the lookout for not-for-profit entities that overpay officers, directors, trustees or key employees at the expense of the entity’s qualified charitable purpose. For these organizations, the IRS may impose an excise tax on compensation paid to insiders that exceeds what is considered reasonable.

Quantifying Reasonableness

The IRS defines reasonable compensation as “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” In addition to salaries and bonus payments, compensation may include such items as benefits, stock options, low-interest loans, paid time off, discounts, personal use of company assets, and other perks. The IRS may even evaluate management and consulting fees, rent expense, and covenants not to compete as places to disguise payments to owners and managers.

Your organization’s compensation committee should generally use five factors to determine appropriate compensation levels:

  1. The employee’s role. Look at his or her position, hours worked and duties performed. Also consider the employee’s personal attributes, including his or her training, experience, education and willingness to personally guarantee the company’s debt.
  2. Comparisons with other companies. Consider industry publications, public stock data or compensation surveys that publish comparable data.
  3. Company’s character and condition. Evaluate company size, financial performance, complexities, and general economic conditions. For example, a company may sometimes cut back on owners’ salaries when cash is tight — and subsequently increase it to “catch up” for paying below-market salaries.
  4. Internal consistency. The IRS will compare what your company pays owner-employees to what is offered to other unrelated employees and subordinates.
  5. Potential conflicts of interest. Examples include related party transactions and control over decision-making.

The U.S. Tax Court also relies on an “independent investor test.” This bottom-up approach suggests compensation is reasonable if the company’s return on equity (after payment of the owner’s compensation) would satisfy a hypothetical independent investor.

Need Help?

Quantifying reasonable compensation can sometimes be a sensitive and complex issue. Rather than make a personal judgment about how much an individual’s contributions are worth, the IRS will allow deductions for only the portion that it considers reasonable. Any deductions above or below that amount will be disallowed and can result in adverse tax consequences.

For more information on how much compensation is considered reasonable, considering your organization’s unique facts and circumstances, please contact a member of our tax services team.

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