Items and factors to consider in setting reasonable compensation

Editor: Valrie Chambers, CPA, Ph.D.

Whether amounts paid by businesses to shareholder-employees qualify as deductible compensation or should be characterized as distributions or gifts has long been a source of tax controversy, one that often requires a careful analysis of all facts and circumstances to establish the correct characterization of the payments. To appropriately perform this analysis, all companies should maintain supporting documentation for the payments. Compensation for higher-paid employees and executives is especially at risk of IRS scrutiny.

Sec. 162 provides that only ordinary and necessary expenses incurred in carrying on a trade or business are deductible. Regs. Sec. 1.162-7(a) sets forth two requirements for compensation payments to be deductible, stating, “The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.” The amount of compensation may be considered reasonable if it is similar to that paid for like services by like enterprises under like circumstances. Factors in determining similar enterprises would include characteristics such as sales, growth, performance, and value. The amount of the compensation alone is insufficient.

Court cases have held that if the purported compensation is a distribution of profits, it is not compensation but is instead a dividend. However, payment for bona fide servicesrendered to the company should qualify to be classified as compensation. For it to be considered payment for services, one needs to consider multiple factors, such as the employee’s qualifications; the employee’s duties; the employee’s background and experience; the employee’s knowledge of the business; the size and complexity of the company; the employee’s time devoted to the company; and the company’s economic condition, both currently and in prior periods.

Some resources that might be helpful in making a determination include the Willis Towers Watson General Industry Compensation Policies and Practices Survey Report, the Economic Research Institute’s compensation analysis services, and the Risk Management Associates Annual Statement Studies, which are all published annually.

Several court decisions may also be pertinent. O.S.C. & Associates, Inc., 187 F.3d 1116 (9th Cir. 1999), addressed what the court found to be “overwhelming evidence” that the taxpayer’s intent was to distribute profits and not to pay compensation for services. For reasonableness of the amount of compensation, see also Owensby & Kritikos, Inc., 819 F.2d 1315 (5th Cir. 1987); Rapco, Inc., 85 F.3d 950 (2d Cir. 1996); and H.W. Johnson, Inc., T.C. Memo. 2016-95. Mayson Manufacturing Co., 178 F.2d 115 (6th Cir. 1949), and Miller & Sons Drywall, Inc., T.C. Memo. 2005-114, described recognized methods using a multifactor approach for determining when compensation is reasonable. Cases that review whether amounts paid represented compensation for services performed prior to the tax year at issue include American Foundry, 59 T.C. 231 (1972), and Perlmutter, 44 T.C. 382 (1965). R.J. Nicoll Co., 59 T.C. 37 (1972), demonstrates that the burden of proving proper compensation is with the taxpayer.

Publicly traded companies often have reference thresholds, compensation committees, transparency in their SEC reporting requirements, Sec. 162(m) requirements regarding annual compensation exceeding $1 million, and other disclosure requirements, all of which can aid in determining the reasonableness of their compensation policies. Privately held companies often do not have as much data regarding compensation available, making compensation issues more vulnerable to controversy.

According to a 2014 internal IRS guide Reasonable Compensation: Job Aid for IRS Valuation Professionals (“Job Aid”), reasonable compensation levels are typically analyzed by the market approach, the income approach, and the cost approach. The market approach is the most commonly used and is generally favored by courts, the Job Aid states.

The facts and circumstances surrounding a payment are key to determining whether any or all of a payment is classified properly as compensation. For closely held companies established as C corporations, the concern is the payment of excessive compensation to shareholder-employees. S corporations, on the other hand, are concerned with the possible underpayment of compensation to their shareholder-employees, which allows the S corporation to avoid payroll and unemployment taxes.

CPAs should consider advising their business clients to hire a valuation analyst. A valuation analyst can analyze the reasonableness of a closely held corporation’s compensation of shareholder-employees. Benefits of engaging a valuation analyst include that an independent third-party analysis should provide greater support to the reasonableness of compensation amounts in any IRS examination. Also, an analyst could provide expertise for other, nontax considerations regarding compensation, including owner transition, litigation, and corporate governance. An analyst report would become part of the documentation supporting compensation levels.

Higher and lower compensation amounts are much more difficult to compare when looking at privately held companies. Issues of unreasonably high compensation could arise, for example, when a company pays a family member employee more than the services performed are worth. The business then tries to claim a tax deduction for what should be considered a gift to that family member, potentially creating a secondary gift tax issue. Compensation may also be unreasonably high because it includes amounts that should be dividends to the shareholder-employees. In addition, unreasonably high compensation may be used to increase the amount that can be contributed to shareholder-employee retirement plans, such as SEPs or Keoghs.

Similarly, in the context of S corporations, compensation amounts that appear lower than under comparable circumstances could nonetheless be reasonable if they reflect, for example, an employee’s reduced role in retirement or the company’s economic constraints. Compensation is likely to be considered unreasonably low, however, if it results from a shareholder-employee’s desire to avoid paying higher employment taxes by receiving a relatively low salary but with relatively large distributions. Besides exposing the company to additional payroll taxes, penalties, and interest if the IRS detects it, this tactic could also negatively affect the Social Security earnings of the shareholder-employee for retirement. Other, broader questions could also be in play if compensation is unreasonably low. For example, it could devalue the services provided by an employee, which in turn could negatively impact a future sale of the company, hiring new executives, etc. Unreasonably low compensation could also affect an employee-shareholder’s employee health insurance eligibility.

Compensation will continue to be an area of controversy. Whether they are publicly traded or privately held, entities will continue to struggle with the possibility of having to justify their compensation levels. Companies need to properly document all facts, circumstances, and strategies used to reach the compensation levels paid for a given year.

Tax reform alert: Tax reform legislation enacted in December could affect tax provisions
discussed in this item.

This item was prepared with Donna Sauter, CPA, who is a member of the AICPA Tax Practice and Procedures Committee.