IRS offers ways to determine Reasonable Compensation in Not-for-Profit and For-Profit entities

The IRS, as part of their audit programs, regularly encounters contentious issues in a tax audit of a business.  One of theses is determining the appropriateness of an amount of compensation paid to owner/employees.

For instance:

  • Businesses that pay compensation to employees who are also shareholders may in fact be paying, as compensation, amounts that are disguised dividends.  For “C” corporations this would create additional corporate income and would result in additional corporate tax liabilities.
  • Small family businesses may pay other family members, in particular their children, compensation for purposes of support or income diversion away from the owners. Is the compensation reasonable or is it in fact a disguised dividend?
  • Many business owners will borrow money from their closely-held business and not repay the loan or charge adequate interest rates.  The IRS will consider this as a form of dividend or payroll, depending on the facts and circumstances.
  • In “S” corporations and partnerships, in particular those with multiple owners paying one or more of these owners with compensation for services, how can one determine which owner is being paid fairly and which is being overpaid?

The IRS tax code section 162 generally governs these situations.  IRS valuation professionals use several tools to determine compensation appropriateness, including:

  1. Comparables/market comps.  This analysis would use data from other companies having similar employment relationships.  The compensation paid to employees working comparable hours with comparable skill sets are measured against the business under audit to determine if the compensation paid by the business is reasonable. This approach is the most common and is preferred by courts as the optimum way to measure reasonableness.
  2. Income. The “Individual Investor Test” is analyzed.  This looks at the profits of the business and whether an investor is satisfied with this return on investment.  If the investor is okay, then the compensation is reasonable.
  3. Cost.  This approach breaks down the various components of the job duties and hours worked to determine if each sub-category is paid reasonable compensation.

This can be a complicated tax area.  The owners, and their managers, must be aware of these potential audit issues.  For more information, please contact a member of the ShindelRock tax team.