Small-Business Tax Tips: Reasonable Compensation

Since 2010, small-business owners have seen a significant uptick in reasonable compensation challenges, as the IRS has increasingly trained its tax examiners to examine payroll tax issues — among them, reasonable compensation. After all, the payment of a salary in excess of what the IRS considers “reasonable,” the payment of personal expenses by the business, and salary paid to a relative who performs no services for the business can all result in a so-called constructive dividend in the eyes of the IRS.

Unfortunately, the owners of many garden and pond businesses rarely have sufficient documentation to back up their numbers. Not too surprisingly, the IRS will typically set a high number — usually near the Social Security maximum — if it determined that the reported salary is not defensible. But what exactly is “reasonable?”

Limited Liability vs. S Corporations

In a sole proprietorship, all income from the pond operation or business goes into the owner’s pocket, while expenses are paid from those pockets, and anything left is labeled as profits and taxed. Although a sole proprietor is often legitimately called an employee of the business, in reality, the owner is the business.

Largely due to liability considerations, the sole proprietorship is becoming increasingly rare. Today, the limited liability (LLC and LLP) entities are most often selected by new small businesses. The S corporation, however, remains the single most popular entity, affording flexibility and some protection from liability.

 An S corporation is simply an incorporated pond retailer, distributor or builder that has chosen S corporation status. In general, an S corporation does not pay income tax. Instead, the corporation’s income and deductions are passed through to shareholders, much like a partnership. The shareholders report the income and deductions on their own income tax returns.

Unfortunately, when it comes to an incorporated pond business, the tax treatment of a dividend can be harsh. It’s not deductible by a regular corporation, but it is income to the shareholder or recipient. An incorporated pond business does not have to formally declare a dividend for the owner or shareholder to face a bill for a taxable dividend. In fact, there doesn’t even have to be a distribution.

“Reasonable” Compensation

When it comes to S corporations, the IRS believes that to the extent the owners perform services for their business, the business is required by law to pay that owner a reasonable salary as compensation for those services. In addition, and crucially, that reasonable salary is subject to self-employment tax.

The IRS’ goal is to prevent S-corporation owners from exploiting a payroll tax loophole by requiring them to pay themselves reasonable compensation for their services before taking distributions. As a result, the main focus of IRS examination of the tax returns of S corporations — and all incorporated businesses — over the past decade or so has focused on determining whether the compensation amount paid to the owner was “reasonable” based on the services provided.

The courts, including one case that went all the way to the Supreme Court, have consistently supported the IRS’s methodology, while shedding light on the many issues involved. The bottom line is, the amount of reasonable compensation taken must be reasonable for all the services the pond business owner performs, and that reasonable compensation is triggered by distributions — not profit or loss.

Determining “reasonable” has been made more difficult because neither the IRS nor our lawmakers have provided business owners with adequate specific guidance. Obviously, pond business owners must pay themselves, but how much? Among the factors the IRS and the courts will weigh in making its reasonable salary determination include compensation of nonowner employees, past salary history, industry formulas and the financial condition of the business.

However, even though all these factors are considered, the most heavily-weighted consideration appears to be summarized as the replacement cost to the business of hiring an outside party to perform the duties of the business owner.

In a recent court case, (H.W. Johnson, Inc., T.C. Memo. 2016-95), the taxpayer was able to show the court that salaries were not excessive. The two brothers managed the business and received salaries of some $2 million each in 2003 and $3.6 million each in 2004. The Court noted the brothers increased sales from 2002 to 2004 from $23 million to $38 million and managed to keep the business operating efficiently during a time when similar businesses in their locale and field faced financial difficulties. The court also noted that the business had a formula for determining bonuses and dividends, and the brothers stuck to that formula.

“Reasonable” in the Eye of the Beholder

Questions about salaries paid to the owner-employee include whether payroll taxes have been or should have been withheld; whether those distributions have, more accurately, been labeled as dividend payments; and will the business be penalized with the dreaded “Accumulated Earnings Tax,” because it keeps profits in the business rather than paying those profits to the owner-employee in the form of either wages or dividends.

Generally, the owner-employee of a profitable pond business should receive both wages and dividends. The business can reward owner-employees with both bonuses and fringe benefits, although favoring the owner-employee at the expense of others within the business is a definite no-no in the eyes of the IRS.
Owner-employees must, of course, include some — but not all — of the amounts received from their business in their taxable income, although the tax rate usually varies depending on the type of payment. The pond business can generally claim a tax deduction for some but, again, not all those amounts distributed or paid to owner-employees as wages or salaries. Dividends paid by the business to shareholders are not tax-deductible by the business.

Dividends as Employee Compensation

As mentioned, the profits of a closely-held pond retailer, distributor or builder can be distributed as wages or as dividends. Double-taxation, once at the corporate level and once at the shareholder level, is an expensive problem for many owner-employees.

Typically, a closely-held, incorporated business avoids double-taxation by paying most of its profits in the form of a bonus, or by leaving profits in the business as accumulated earnings. The IRS, obviously, has a field day recharacterizing bonuses as nondeductible dividends. The nonpayment of sufficient dividends relative to profits can subject incorporated pond businesses to the accumulated earnings tax — a penalty for retaining already-taxed profits in the business rather than distributing them as dividends.

Reasonable, Reasonable Compensation

The IRS and the courts frequently scrutinize the year-end bonuses paid to owner-employees because of the possibility of a disguised dividend. Each year, the IRS reminds incorporated businesses, including S corporations, that they must pay reasonable compensation to shareholder-employees in return for the services that they provide to the incorporated pond business before a nonwage distribution may be made to that shareholder-employee.

The tax treatment of fringe benefits paid to employees of an S corporation is different from owner-employees who are not shareholders, or who own 2 percent or less of the outstanding S corporation stock. The fringe benefits paid non-shareholder employees are tax-free. They are excluded from the employee’s taxable wages. Those non-shareholder fringe benefits are deductible by the corporation.

Employee-owners owning more than 2 percent of the S corporation stock, on the other hand, are not considered employees for fringe-benefit purposes, and their fringe benefits may not be tax-free. Owners of more than 2 percent of the corporation are treated in the same manner as partners in a partnership.

Self-Employment Tax

Although shareholders of a so-called S corporation are treated much in the same manner as partners, they are not subject to the self-employment tax on their share of the S corporation’s ordinary income attributable to the operation of the business. After all, a corporation is a separate entity for tax purposes.

Provided an S-corporation shareholder is an employee who has received an actual distribution, the only remaining questionable area is what is a “reasonable” amount for that particular shareholder-employee. Whether amounts paid for services provided are “reasonable compensation” depends on all relevant facts and circumstances.

Questions Lead to More Questions

So-called “reasonable compensation” has always been an issue for incorporated businesses. With the Accumulated Earnings Tax raised from 15 percent to 20 percent of an operation’s accumulated earnings, reasonable compensation that is too high for regular C corporations but too low for S corporations is rapidly becoming an issue.

While promises of tax reform continue to float in Washington, the only changes likely to have an impact on the compensation of pond retailers, distributors or builders are the promised lower tax rates. In order to both profit from and avoid the potential pitfalls of reasonable compensation in the face of accumulated earnings, early planning is essential before an audit results in headaches and expensive penalties.

Seeking professional guidance for reaping those tax breaks due can ensure that you, the owner-employee of the pond business, don’t run afoul of the tax laws. The need for professional assistance can’t be emphasized enough, as the IRS is watching.

With 25 years of professional experience in the fields of taxes and finance, Mr. Battersby writes on unique and topical subjects in the industry. Although no reputable professional should ever render specific advice at arm’s length, he does craft unbiased, interesting, informative and accurate articles. Mr. Battersby currently writes for publications in a variety of fields. His topical columns are syndicated in many publications each week. He also writes columns for trade magazines and has authored four books.

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