Scrutiny of Executive Compensation

Stephen D. Kirkland CPA, CMC, CFC, CFF
May 26, 2012 — 2,177 views  
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The Internal Revenue Service continues to examine income tax returns filed by closely held corporations which reflect potentially unreasonable compensation for the shareholders.  

In the case of a C corporation, IRS auditors look for compensation amounts that may be unreasonably high.  A shareholder may have set his or her compensation level too high and not drawn a dividend from the company in order to minimize the overall tax impact.  The IRS then proposes to disallow the corporation’s deduction for the unreasonable portion of the compensation.  

In the case of an S corporation, the exact opposite occurs.  Revenue agents look for a shareholder who received unreasonably low compensation.  An S corporation shareholder may be tempted to take modest a salary, which is subject to payroll taxes, and also take large cash distributions, which are not subject to payroll taxes.  

In both scenarios, the tax laws state that each shareholder should be paid reasonable compensation for the services actually rendered.  However, there is no hard formula for determining reasonable compensation.  Although many factors are considered, including the individual's qualifications and duties, there is plenty of room for dispute over the value of one person's work.  To complicate this, most executives do not keep written records detailing the hours they work, the decisions they make, or the way they use their relationships and expertise.  Without detailed records, it can be difficult to go back in time and determine exactly what someone did and estimate the value of those services.  An experienced compensation consultant can help guide the process.

Anyone concerned about a potential challenge to their compensation should keep records of at least their key duties and accomplishments.  Ideally, compensation amounts and bonus formulas should be properly authorized in advance.  The basis for determining the compensation should also be noted.  If the compensation includes an incentive, such as cash bonuses, the notations should include an explanation of why the incentive plan was designed the way it was and how the company will benefit.  This may help avoid a visit to U.S. Tax Court.

The IRS also audits tax-exempt organizations to ensure that key employees and independent contractors are not receiving unreasonable compensation.  That compensation may not be in the form of a paycheck, but may be in the form of rent or some other type of income.  The charity’s Board of Directors should understand how compensation amounts are being determined and ensure that they are reasonable.  They should also carefully consider what similar organizations in the area are paying for similar services.  This helps avoid excise taxes which may be imposed on the individuals who permitted unreasonable compensation and on the person who received unreasonable compensation.  It also helps avoid unfavorable publicity which can be damaging to a charity.

For more information on determining reasonable compensation, visit www.ReasonableComp.biz.

Stephen D. Kirkland CPA, CMC, CFC, CFF

Atlantic Executive Consulting Group, LLC

Stephen earned a Bachelorís degree in Accounting at Emory University and a Master of Tax Accounting at the University of Alabama. He is a compensation consultant and expert witness with Atlantic Executive Consulting Group.