Too Much or Too Little? Determining Reasonable Compensation for Your Clients

Many tax practitioners are faced with the following dilemma: as a trusted advisor, you provide guidance so that your business corporation owner clients compensate themselves to minimize their tax liability. However, you are concerned about whether your clients will have the scrutiny of the IRS hanging over their heads in complying with what may be considered “reasonable” compensation.

If this double-edged sword describes a situation you often deal with, then it is important to develop a deeper understanding of the implications of reasonable compensation so you can better strategize your tax position in the event of an audit.

First and foremost, it is important to understand where the IRS is coming from in defining what may be considered reasonable compensation. Regardless of the type of legal entity, the officer-shareholder, according to the IRS website, should be paying themselves “wages [that] are supposed to be commensurate with [his or her] duties.” Further guidance is contained in Publication 535, Business Expenses, which contains specific factors that should be considered in determining what may be reasonable.

As the implementation of IRS rules and regulations are ultimately interpreted through tax court cases, the last several decades have seen these guidelines tested several times. One noteworthy tax court case in 1983, Elliotts, Inc. v. Commissioner, highlighted five factors that are analyzed in determining reasonable compensation:

1. The employee’s role in the company.
2. A comparison of the employee’s salary with those paid by similar companies for similar services.
3. The character and condition of the company.
4. Potential conflicts of interest.
5. Evidence of an internal inconsistency in a company’s treatment of payments to employees.

Keep in mind that when the IRS reviews a potential audit candidate for reasonable compensation compliance, it will perceive the taxpayer’s incentive to stray from reasonable compensation guidelines differently depending on the type of legal entity involved. However, shareholder employees of C or S corporations face a different set of concerns. A business owner structured as a C corporation will be incentivized to maximize their salary to avoid paying the additional profit leftover in the business as dividends, thus avoiding double taxation. These “disguised” dividends have been the basis of many cases, inclusive of the Elliotts case.

On the other hand, an S corporation owner-shareholder will desire the lowest feasible salary to potentially minimize Social Security and Medicare contributions. Since an S corporation is a flow-through entity, cash that would have been taxed as payroll can be distributed as previously taxed income without this additional layer of taxation.

Non-profit organizations are also not exempt from the scrutiny of the IRS. In some cases, executives are authorized to increase their own compensation. If the compensation is in excess of reasonable levels, the excess is classified as an “extra benefit transaction” and can be assessed excise tax per Internal Revenue Code Sec. 4958. Note that these extra taxes are assessed on the individuals responsible as opposed to the non-profit organization.

As a tax practitioner, it is important to consider other factors beyond minimizing tax liabilities resulting from adjusting officer compensation. For example, retirement plan contribution limits are derived from W-2 wages. Thus, if an S corporation owner-shareholder is contributing to, for example, a solo 401(k) retirement plan, he or she would potentially be reducing their maximum potential contribution to such a plan. Over a long timeframe and with an aggressive investment strategy, this can make a significant difference in reducing the potential pre-tax retirement balances that one might be able to accrue.

Compounding this retirement scenario further would be the effect of lower wages on the calculation of Social Security benefits. As these benefits are based a contributor’s lifetime W-2 earnings, it is possible that a shareholder-owner may be lowering their calculated retirement income. Ultimately, the yearly tax savings by reducing S corporation wages may eventually result in your client ending up in a retirement situation that’s not as favorable.

The Tax Cuts and Jobs Act created tax planning considerations in reasonable compensation for S corporations. Because the new Sec. 199A qualified business income deduction is based on K-1 income, reducing an employee-owner’s W-2 income would have the effect of increasing K-1 income, thus maximizing the potential benefit of the Sec. 199A deduction.

As you can see, there are a lot of factors to consider when advising your business owner clients how to compensate themselves. When taking a position on reasonable compensation, it is critical to document and analyze your client’s tax situation carefully to balance the risk of an audit against potential savings realized.

Editor’s note: This article was originally published on March 16, 2018, and republished with updates on Aug. 13, 2019.