The IRS routinely encounters contentious issues in business tax audits, particularly regarding the appropriateness of compensation paid to owners/employees.
For example:
Businesses that compensate employees who are also shareholders may inadvertently classify payments that should be dividends as compensation. This misclassification can lead to additional corporate income for “C” corporations, resulting in higher corporate tax liabilities.
Small family businesses might pay family members, especially children, for support or income diversion from owners. Evaluating whether such compensation is reasonable or actually a disguised dividend is crucial.
Many business owners borrow funds from their closely-held businesses without repayment or at inadequate interest rates. The IRS might view these transactions as disguised dividends or underreported payroll, depending on the circumstances.
In “S” corporations and partnerships with multiple owners, determining fair compensation for services provided by owners can be complex. This scrutiny falls under IRS tax code section 162.
IRS valuation professionals employ several methods to assess the appropriateness of compensation, including:
1. **Comparables/Market Comps:** This involves comparing compensation paid by the audited business to similar companies with employees in comparable roles (similar hours and skill sets). Courts generally favor this method as the most reliable way to determine if compensation is reasonable.
2. **Income Analysis (Individual Investor Test):** This method assesses whether the profits generated by the business justify the compensation paid to owner/employees. If an investor would find the return on investment satisfactory, the compensation is likely deemed reasonable.
3. **Cost Analysis:** This approach breaks down job duties and hours worked to evaluate if each component of the compensation is reasonable based on industry standards and business performance.
These tools help the IRS evaluate whether the compensation practices of a business are in compliance with tax regulations, ensuring that payments to owner/employees are appropriately categorized and reported.
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 [1].