Unreasonable Compensation and the IRS

Stephen D. Kirkland CPA, CMC, CFC, CFF
December 15, 2010 — 2,748 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.
Many executives are well paid in corporate America, and people are asking whether the amounts paid are excessive and unreasonable compensation.  Since the answer to that question has dramatic tax consequences at privately-owned companies, Internal Revenue Service (IRS) auditors are looking closely at executive compensation.   Pursuant to Internal Revenue Code section 162, corporations can deduct "ordinary and necessary" expenses incurred in carrying on their businesses.  This includes compensation for services performed by stockholders and their family members, but only if the amounts paid are "reasonable" for the services performed.  On the other hand, dividends distributed to shareholders are not deductible.  This creates a potential tax planning opportunity for those who both own and work at a business.   C Corporations   C corporations pay income tax on their net earnings and then they may distribute some of the after-tax earnings to shareholders as non-deductible dividends.  The shareholders must pay income tax on the dividends they receive, so corporate earnings are effectively taxed twice, once at the corporate level and once at the shareholder level.   To avoid double taxation, shareholder/employees may increase their compensation and reduce or eliminate dividends.  But they need to be careful not to increase compensation to unreasonable levels.   A closely-held C corporation paying unreasonable compensation to a shareholder-employee is required to treat the excess portion as a dividend (provided there are adequate earnings and profits) rather than as compensation.  Again, this has unfavorable tax consequences for the company, since a dividend is not deductible, but compensation is deductible.    Although the Internal Revenue Code limits deductions to reasonable amounts, it does not define "reasonable compensation."  Whether compensation is reasonable depends on all the facts and circumstances.  The analysis can be complex and requires careful judgment.  For example, compensation may be considered to be reasonable if the same amount was paid for comparable services provided by someone other than a stockholder.  A true comparable, however, is rarely available.  This leads to disagreements between business owners and IRS agents.   Most of these issues are resolved through the IRS appeals office.  If not resolved there, the next step may be to go to tax court.  If a company goes to tax court, a compensation consultant (expert witness) may testify and provide an experienced opinion as to whether the amounts paid were reasonable or unreasonable.  The expert witness may consider many factors, including how much a shareholder-employee would be paid if the business was owned by someone else (an unrelated investor).  After payment of all compensation, were there enough earnings left in the company to satisfy this hypothetical investor?  If so, that may be one factor which suggests that the compensation was not unreasonable.   To determine a reasonable level of pay for an employee, an expert witness normally considers many additional factors.  For example, we look at the employee's input - long hours, special skills, relationships, years of experience and education brought to the job.  These are very important factors, but it can be difficult to quantify the value of someone's knowledge, relationships, leadership and vision.   We must also look at the employee's output, or the results he or she achieved.  After all, pay for key employees should be performance-based.  Consider new clients and contracts brought to the company, increases in profitability, and similar accomplishments.  Measuring one person's accomplishments can be difficult and time-consuming, however, since many accomplishments could come from the efforts of several people working together.   We also consider the size of the company, the complexity of the industry, economic conditions, the geographic location and other factors.    An executive's compensation for a particular year may include an amount for services he or she performed in an earlier year.  Business owners often receive reduced pay in the early years of a business, even though that may be when they work the hardest.  They also may not be adequately paid during periods of rapid growth, when cash flow is tight.  If so, they may be entitled to catch-up pay later.  If an employee will be underpaid until a new business becomes profitable, and will receive proportionately larger pay later, consider stating that in board minutes or an employment agreement.   In addition to an employee's salary, employer-provided benefits should be considered in determining whether an employee's compensation is reasonable.  This includes pension and welfare benefits, as well as fringe benefits such as personal use of a company car.  An otherwise high salary might be reasonable if the employee's benefits are less than those usually provided to a comparable employee.   Due to the potentially adverse tax consequences, shareholder-employees should carefully document the reasonableness of their compensation and explain how the amounts were determined.  Documentation should describe each person's duties and the unique and valuable nature of the individual's skills and of the services provided.   If a year-end bonus is to be awarded, the terms should be written out in advance.  The bonus may be equal to some percentage of the increase in pretax profits over the prior year, for example.  If awarded, a resolution should explain how and when the bonus was earned and computed.   S Corporations   S corporations, on the other hand, may be inclined to keep the compensation of shareholder-employees low.  This is because their compensation is subject to payroll taxes, but distributions to stockholders are not.  (Either way, S corporation earnings are subject to income tax only once.)    Federal and state tax authorities are aggressively reviewing S corporations to see if they paid wages that were so low as to be considered unreasonable compensation.  They want to ensure S corporations pay enough payroll taxes on funds turned over to stockholders.    On the other hand, an S corporation must be careful not to over-compensate any shareholder.  If the IRS determines that one shareholder was overpaid, the excess compensation may be treated as a distribution to that one shareholder.  This could create a disproportionate distribution to that shareholder.  Since the IRS can terminate a company's S status for making a disproportionate distribution to one shareholder, the S status could be terminated as of the date of the over-payment and the company would be treated as a C corporation thereafter.  Therefore, subsequent distributions would be subject to two levels of tax.   As with C corporations, unreasonable compensation should be avoided and records should be kept to support how compensation levels were determined.   Charities   The Internal Revenue Service also keeps a close eye on tax-exempt organizations to ensure that their exempt status is not abused.  Under Internal Revenue Code section 4958, the IRS can impose a 25% excise tax on the excess portion of unreasonable compensation received by a key employee.  The IRS can also impose a 10% excise tax on officers or directors who permitted the excessive payment.  These excise taxes are imposed upon the individuals, not on the charity.   The Code refers to this unreasonable compensation as an "excess benefit transaction" because the executive is getting a benefit (compensation) in excess of the value of services he or she provides in exchange.  To protect themselves from these excise taxes, and from bad publicity, many charitable boards obtain opinion letters from independent compensation consultants.  See www.CompensationOpinion.com for more information on compensation opinion letters.   FIN 48   In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48").  Under FIN 48, preparers of financial statements must recognize and measure uncertain tax positions taken by the company.  Among other things, disclosure of the potential impact of these positions is required.  This includes estimating and disclosing the amount of the company's potential tax assessments.  One of the issues comprehended by FIN 48 is a potential tax assessment due to payment of unreasonable compensation.   Who else is asking?   IRS agents are not the only ones concerned with compensation amounts that may be excessive.  Many parties have a vested interest in this issue.  Directors, shareholders, creditors, bankruptcy trustees, and others are looking closely at the compensation packages executives craft for themselves.  And they all have their own opinions as to what an employee's services are worth.  But not everyone understands the complex factors which come into play.  So, the reasonableness of executive compensation packages may continue to be one of the most debated issues in the business world for years to come.   Our income tax laws change often.  Please advise your clients to work closely with appropriate advisors in structuring compensation plans to avoid costly mistakes.

Stephen D. Kirkland CPA, CMC, CFC, CFF

Atlantic Executive Consulting Group, LLC

A native of Charleston, South Carolina, Stephen earned a Bachelorís degree in Accounting at Emory University in 1981. He earned a Master of Tax Accounting at the University of Alabama in 1982. He then spent ten years with PricewaterhouseCoopers before co-founding a regional firm. In 2006, he became a member of Atlantic Executive Consulting Group, LLC.