Reasonable Compensation: An Enduring Tax Issue

October 20, 2009

Many business headline stories in recent months have focused on whether executives of public companies (especially those that have received TARP money from the government) are paid more than they are worth. However, the issue of reasonable compensation is a tax issue that involves Main Street companies more often than Wall Street companies. The tax issue is whether payments made by a closely held "Subchapter C" corporation (i.e., a corporation that is subject to federal corporate income taxation) to an individual who is both a shareholder and an employee of the corporation is (1) salary or bonus payments which can be deducted, or (2) dividends which cannot be deducted. Revenue used to pay dividends is subject to double taxation, at both the corporate and shareholder level, whereas money used to pay salaries is in essence taxed only to the employee.

Written Compensation Programs Help Ensure Deductibility. To constitute deductible compensation, payments have to meet two tests. They must be (i) intended as compensation for current or past services and (ii) reasonable in amount compared to the value of the services. Proper planning and documentation can be helpful in establishing the intent to compensate factor, as is indicated by a recent opinion dealing with a home improvement company with stores throughout the Midwest. The Seventh Circuit Court of Appeals' decision in Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), states that setting a bonus based on a pre-set percentage of the corporation's net income (as opposed to a set fixed dollar amount) is an indication of intent to compensate for services. The Menard Court also stated that an intent to compensate for services was evinced by a prior agreement that, should all or a portion of the bonus ultimately be determined to be in excess of an amount of reasonable compensation, the shareholder-employee will be required to reimburse the corporation for the excess amount.

Factors to Determine if Compensation is Reasonable in Amount. Federal courts have adopted varying tests to determine whether compensation is reasonable in amount. Courts generally apply multiple factors. These factors include the shareholder-employee's qualifications; the nature and scope of the shareholder-employee's duties; the size and complexity of the corporation's business; and a comparison of the shareholder-employee's compensation with (1) compensation received by other employees (within the same corporation and with other employers in a similar business), (2) the corporation's gross and net income, and (3) the amount distributed by the corporation as dividends. Other courts have relied more, to one degree or another, on a rebuttable presumption that if the other investors in the corporation are receiving a far higher return on their investment than they had reason to expect, the shareholder-employee's compensation is reasonable in amount.

With an S Corporation, the Roles are Reversed. In the case of a "Subchapter S" corporation (which is not subject to federal income taxation) the respective positions of taxpayers and the Internal Revenue Service are often opposite what they are for "Subchapter C" corporations. Payments to a shareholder-employee that are treated as compensation are subject to federal wage ("social security") taxes of up to 15.3%, so shareholders want to maximize dividends and minimize compensation income. In the case of a family-owned "Subchapter S" corporation, the IRS can reallocate income to reflect the value of services rendered by a shareholder-employee.

Capital Gains Tax Changes in 2010 Will Increase the Importance of Compensation Being Deductible. The favorable tax treatment for qualified dividends (currently taxable at a maximum rate of 15%) is set to expire after 2010. Unless this favorable rate is extended, taxpayers' incentive to have payments made by "Subchapter C" corporations to shareholder-employees treated as deductible compensation will be even greater than it has been for the last several years.

Foresight and planning are crucial in being successful against an IRS challenge based on the reasonableness of compensation paid to corporate owner-employees. Attorneys at Frost Brown Todd LLC stay abreast of reasonable compensation developments, as well as a wide variety of other federal and state tax issues that have a great impact on businesses of all sizes. Contact James Anderson, Marty Mooney or any other member of Frost Brown Todd's Tax Practice Group for assistance with compensation issues.