Reasonable (or replacement) owners’ compensation can be a hot button during IRS audits, divorces, shareholder disputes and other litigation matters involving the value of a private business. What’s appropriate depends on the facts and circumstances.
Applying federal tax guidance
The IRS is on the lookout for C corporations that pay employee/shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid because salaries are a tax-deductible expense and dividends aren’t. Owners 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 corp is overpaying owners, it may reclassify part of the owners’ salaries as dividends.
For S corporations, the IRS looks for businesses that underpay owners’ salaries to minimize federal and state payroll taxes. Rather than pay large salaries, S corps are more likely to pay distributions to owners because they’re generally tax-fee to the extent that the owner has a positive tax basis in the company.
Parties in a civil lawsuit also may disagree significantly about how much an owner’s contribution is worth. This issue typically arises in situations where maintenance and child support payments are contingent on an individual’s salary or where unreasonable salaries affect the value of a closely held business.
That’s where objective resources — such as “Reasonable Compensation: Job Aid for IRS Professionals” — may come into play. The IRS job aid states, “Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” This document provides a systematic approach to estimating what’s reasonable and how to size up an owner’s total compensation package.
Taking a comprehensive approach
Before compensation can be assessed as reasonable, all components must be calculated, including:
- 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,
- Reimbursement of 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, discounted services or products, and contracting work done at cost (or below).
The IRS job aid warns that, besides salaries, owners’ compensation may be buried in such items as management and consulting fees, rent expense and noncompete covenants.
Customizing the estimate
The IRS job aid also provides some rules of thumb to help assess whether compensation levels are reasonable. For example, it says that owners’ compensation should typically be less than 10% of annual sales for mature midsize and large companies. But reasonable compensation levels can vary substantially depending on the industry, the size and financial performance of the company, the qualifications and responsibilities of the owners, and other factors. For example, owners’ compensation as a percentage of annual sales is generally higher for smaller companies.
The five areas that courts generally consider when evaluating reasonable compensation are:
- The individual’s role in the company,
- External comparisons of the salary with amounts paid to similar individuals in similar roles,
- Character and condition of the company,
- Potential conflicts of interest between the individual and the company, and
- Internal inconsistency in the way employees are treated within the company.
Owners can control compensation, and that creates an inherent conflict of interest. External comparisons are key to supporting compensation levels. The IRS job aid recommends interviewing owners to get a clearer picture of their experience, duties, knowledge and responsibilities. It also lists several sources of objective market data that can be used to support compensation levels, including salary surveys published by trade groups or industry analysts, proxy statements and annual reports of public companies, and private company compensation reports.
We can help
Reasonable compensation levels are important not only for state and federal tax purposes but also for accurately estimating the fair market value of the business. If you have questions regarding owners’ compensation, contact us. Our business valuation pros can help you get it right.