The IRS may challenge the reasonableness of compensation a business pays to its owners and other related parties under a variety of situations. This article explains the factors to consider when evaluating compensation paid by C corporations and pass-through entities, including S corporations, partnerships, and limited liability companies (LLCs) treated as partnerships for tax purposes.
Framing the Issue
Internal Revenue Code Section 162 allows the deduction of ordinary and necessary business expenses, including reasonable compensation. Sec. 162 defines reasonable compensation as the amount that would ordinarily be paid for like services by like organizations in like circumstances.
Sometimes, the IRS claims that a C corporation has overpaid an individual and reclassifies excessive payments as disguised:
Dividends: Dividends are taxed twice. Unlike compensation payments, dividends aren’t deductible for federal income tax purposes. So, the corporation pays income tax on the earnings. Then, the recipient pays personal-level tax on the dividend income.
Gifts: The IRS may say that an overpaid relative received a disguised gift, which may be subject to gift tax if it’s above the annual exemption (which is $15,000 for 2018) – unless the donor taps into his or her lifetime estate and gift tax exemption ($11.18 million for 2018).
When assessing reasonable compensation, the IRS looks at the full compensation package, including W-2 wages and other perks. Loans the business makes to owners and other related parties at no or low interest could represent another form of compensation.
When it Might Be Understated
Sometimes, S corporations may try to underpay shareholder-employees to avoid federal and state payroll taxes. Then the company makes up for the below-market salary by making cash distributions to the owner(s) that aren’t subject to payroll taxes.
The Tax Cuts and Jobs Act (TCJA) could provide an extra incentive to underpay owners of pass-through entities: the deduction for up to 20% of qualified business income (QBI). Reasonable compensation paid to owners of a qualified business (including guaranteed payments to partners and LLC members treated as partners for tax purposes) must be deducted when computing QBI. So, the lower the compensation deductions, the higher the QBI deduction for qualified businesses.
However, the QBI deduction is also limited to 50% of the W-2 wages paid by a qualified business. This limitation doesn’t kick in until a taxable income threshold is reached at the owner level: $157,500, or $315,000 for a married joint-filer. Reasonable salaries paid to S corporation shareholder-employees count as W-2 wages for purposes of computing this limitation. (Guaranteed payments to partners and LLC members treated as partners don’t count as W-2 wages.)
For example, suppose a single-owner S corporation has QBI of $1 million after deducting $250,000 of owners’ compensation and $300,000 of W-2 wages paid to non-owner employees. Its QBI deduction would be $200,000. This equals the lesser of 1) $200,000 (20% of $1 million), or 2) $275,000 (50% of $550,000 of W-2 wages).
Conversely, if the owner of this hypothetical S corporation increased her salary to $500,000, her QBI would be $750,000. So, the QBI deduction would be only $150,000. This equals the lesser of 1) $150,000 (20% of $750,000), or 2) $400,000 (50% of $800,000).
To complicate matters even further, QBI deductions are limited for certain types of service businesses, such as medical practices and law firms, when an owner’s taxable income exceeds the applicable threshold.
The U.S. Tax Court has historically favored a market approach that compares an owner’s compensation to what employees are paid for performing similar duties at similar companies. Other issues the court considers when estimating reasonable compensation include the following:
- What duties does the individual perform, and how many hours does he or she work?
- Is the company large? Professionally managed? Profitable and growing?
- Was the compensation paid under a formal and consistently applied compensation program?
- Is there a conflict of interest between the company and the individual that could lead the company to label corporate payouts as deductible compensation?
Additionally, the Tax Court usually applies the “independent investor test.” That is, if the company’s return on equity after subtracting compensation payments would satisfy a hypothetical independent investor, the compensation is probably reasonable.
In recent years, the IRS has given significant attention to whether owners of closely held businesses pay themselves too much or too little. The new QBI deduction could heighten that scrutiny. A financial expert can help your clients establish formal compensation programs, based on market-based pay rates. Doing so may help prevent IRS audits and support owners’ compensation deductions if the IRS makes an inquiry.
IRS Guide Offers Reasonable Compensation Insights
The IRS guide Reasonable Compensation: Job Aid for IRS Valuation Professionals provides insight into what IRS agents consider when deciding whether compensation paid by a C corporation to a shareholder-employee seems “reasonable.” Relevant considerations include:
- The company’s process for setting compensation
- Tax return data, including compensation not reported on a Form W-2
- The number of employees at issue
- External salary surveys
- Compensation data from comparable companies (for example, ratio of overall owners’ compensation compared to comparable company sales)
- A taxable income comparison, such as how the compensation affects the company’s taxable income
- Ratios of owners’ compensation to median employee compensation
The job aid lists three general valuation approaches used to determine reasonable compensation: cost, income, and market approaches. It emphasizes how objective market data (the market approach) can be used to estimate reasonable compensation. However, the cost and income approaches, along with financial analysis, can also be used to refine the reasonable compensation amount.