Is it possible to have too much of a good thing? The IRS thinks so, at least in the context of compensation paid to business owners. If an owner’s compensation is deemed excessive, the IRS may dispute deductions for wages that are unreasonable under the circumstances.
A recent U.S. Tax Court case shows that “reasonable compensation” can be an issue even when the contested amount is paid to a veritable one-person dynamo. (Clary Hood, Inc. v. Commissioner, T.C. Memo 2022-15, March 2, 2022.)
Entity Type Matters When Evaluating Compensation
The IRS has published a guide titled, “Reasonable Compensation: Job Aid for IRS Valuation Professionals.” IRS field agents use this guide when conducting audits to help determine what’s reasonable and how to estimate an employee’s total compensation package.
The IRS is on the lookout for C corporations that pay excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t. Shareholder-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.
For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay salaries to minimize state and federal payroll taxes. Rather than pay salaries, pass-through entities are more likely to pay distributions to owners. That’s because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.
From a tax perspective, it makes a big difference if amounts are paid to business owners as compensation or dividends. If the amount is treated as compensation, it’s deductible from the company’s taxable income. Conversely, dividends aren’t deductible, instead they effectively represent a second level of taxation on corporate income.
Important: Different considerations apply to C corporations than to S corporations and other noncorporate entities. See “Entity Type Matters When Evaluating Compensation” at right. For purposes of this article, we focus on how this issue relates to traditional C corporations.
Some companies decide to maximize the tax benefits for amounts paid to employees by bumping up compensation. Here, it’s important to evaluate the individual’s entire compensation package, which may include:
- Direct salaries, bonuses and commissions,
- Stock options and contingent payments,
- Payouts under golden parachute clauses,
- Shareholder loans with low (or no) interest and other favorable terms,
- Company-owned or leased vehicles and vehicle allowances,
- Moving and relocation expenses,
- Subsidized housing and educational reimbursements,
- Excessive life insurance or disability payments, and
- Other perks, such as cafeteria plans, athletic club dues, vacations, and discounted services or products.
In addition, compensation may be buried in such accounts as management and consulting fees, rent expense and noncompete covenants.
If a company pays owner-employees whatever it wants without any restraint, it could get into hot water with the IRS. Typically, when the IRS challenges the amount as being excessive, the difference between the amount paid and a reasonable amount attributable to services actually rendered can’t be deducted. In some cases, additional tax, penalties and interest also may be due.
Factors to Consider
What constitutes “reasonable” compensation for this purpose? Unfortunately, there’s no definitive bright-line test to determine what’s reasonable, but the courts have cited several key factors in their determinations. Although these factors vary slightly from one jurisdiction to another, the following are key indicators of whether compensation is reasonable:
- The employee’s qualifications,
- The nature, extent and scope of the employee’s work,
- The size and complexities of the business,
- A comparison between the compensation paid and the gross and net income of the business,
- Prevailing general economic conditions,
- A comparison of shareholders’ compensation to dividends,
- Prevailing rates of compensation for comparable positions, industries and businesses,
- The company’s compensation policy for all employees, and
- The compensation paid to the particular employee in prior years.
Usually, no single factor is determinative. The decision generally boils down to several factors weighing for or against a reasonable amount of compensation.
Case in Point
In Clary Hood, the taxpayer was a C corporation that operates in South Carolina and specializes in land grading and excavation. At issue in the case were compensation deductions paid to the company’s shareholder-CEO for the 2015 and 2016 tax years.
The family business was founded in 1980 with just two employees and a hodgepodge of used equipment that was valued at less than $60,000. By the end of 2016, the company had grown into a 150-employee company with nearly $70 million in revenue. From 2000 to 2010, growth was modest, and profits were irregular. In fact, the company sustained three years of operating losses (before owners’ compensation) during that period.
Many of its competitors went out of business during the Great Recession of 2008. But the company survived on its reputation and benefitted from the strategic business decisions to:
- Conserve cash outlays by maintaining a low debt profile and not declaring dividends,
- Temporarily reduce employee compensation,
- Withhold owners’ salary, when necessary, to ensure that sufficient funds were available to cover payroll needs, and
- Sell $800,000 of equipment to offset losses and supplement its cash reserves.
Furthermore, in 2012, the company shifted away from one of its largest, most consistent sources of revenue (site grading for Walmart shopping centers). This spurred tremendous growth in other areas. However, despite its financial success, the corporation never declared or paid cash dividends to its shareholders at any time.
Owner’s Role in Operations
Over the years, the shareholder-CEO served many functions at the company, rarely took vacations and typically worked 60 to 70 hours per week (including weekends). In addition, the company employed several other executives, who each had multiple duties, some of which overlapped with the duties of the shareholder-CEO.
No written employment agreement existed between the shareholder-CEO and the corporation during the review period, and no type of formula was used to determine his compensation during the years at issue. The shareholder-CEO received salary of less than $200,000 in each of the two tax years in question, but he was awarded a $5 million bonus in each of those years. The bonuses were paid after a consultation with the company’s accounting firm. The CEO and his financial advisors agreed that the company had undercompensated him in prior years to help keep the company afloat during the Great Recession.
Nevertheless, the IRS issued a notice of deficiency, determining that portions of the shareholder-CEO’s purported compensation for the years at issue exceeded reasonable levels. Specifically, the IRS allowed only about $500,000 of the $5.7 million total compensation paid as compensation for 2015 and $700,000 of the $5.8 million total compensation paid as compensation for 2016. Eventually, the case went to the U.S. Tax Court.
Tax Court Decision
The court began its opinion by acknowledging that the shareholder-CEO was an “American success story.” It also noted that the IRS doesn’t dispute that the owner was entitled to some degree of additional compensation for the prior services he rendered.
The court proceeded to analyze the factors used to determine reasonable compensation. It seemed to place the greatest weight on the prevailing rates of compensation for comparable positions and businesses. It also noted the lack of any dividends paid by the corporation during these years.
In addition, the company had no structured compensation system in place. And the shareholder-CEO’s compensation in the years at issue represented almost 90% of the total compensation paid to all the company’s officers — even though some non-shareholder officers worked nearly the same hours and shared many of the same responsibilities as the shareholder-CEO.
Based on these facts, the court decided that reasonable bonus amounts were approximately $3.68 million for 2015 and $1.36 million for 2016. While these amounts are significantly higher than the estimates provided in the IRS deficiency notice, they’re much less than the amounts the company originally deducted on its 2015 and 2016 tax returns. Plus, the court found the company liable for a substantial understatement accuracy-related penalty for 2016.
Moral of the Story
If your C corporation is awarding bonuses for 2022, it’s important to keep this case in mind. Even if your company deferred bonuses to preserve cash during the pandemic, it can’t just pay whatever it wants to shareholder-employees. Set up and follow a formal compensation policy that rewards executives in a reasonable manner. Also, be ready to face any potential IRS challenges to compensation by keeping detailed records to substantiate amounts paid. Your tax advisor can help you cover all the bases.