Reasonable compensation

Due to our being consultants to the restaurant industry, we are frequently challenged to consider more than overview suggestions about the businesses our clients operate. In some instances, we challenge our clients to consider the risks of being too aggressive in their tax minimization strategy. For example, where our clients are considering paying themselves minimal or no salary for their services and they actually were an integral part of the business operations during the year, we challenge them regarding their salary. There are of course several factors to evaluate in any decision. Are you misleading any user of your financial statements of the true results of operations? Are you objectively evaluating the business fundamentals, return on investment characteristics, are you providing misleading financial information that will be used to calculate your loan covenant ratios, and of course are you reporting your taxable income in a manner consistent with the Internal Revenue Code and the Regulations?

Many with limited knowledge of income tax rules question that this topic is even relevant. What difference does it make where the income is reported provided the income is reported, the taxes paid and the returns filed? This is why we are often looked at as the "bad" guys with our stance regarding reporting of compensation for S Corporation shareholders.

Owners and/or officers who perform services for a corporation are treated as employees, and are paid wages subject to employment tax and other withholding. (This is not necessarily the same treatment as for partnerships and limited liability companies (LLC's) which discussion is beyond the scope of this article). Corporate officers are specifically identified as employees in the Internal Revenue Code. Since wages are deductible by a corporation, the incentive exists to pay the highest wage possible creating a deduction against income for the corporation and reducing the overall income tax obligation of the corporation.

The Internal Revenue Service began attacking this approach many years ago arguing that the compensation was "unreasonable" and therefore not deductible as wages and recharacterized the excess wages as a "dividend". This situation often occurred in corporations where the officer was also a majority stockholder of the company. The owner realized that if he/she were paid wages, that by the process of reporting for income tax purposes, the payment of wages resulted in a lower overall tax burden (to the owner and the corporation collectively) to taking some of the earnings as wages and some as a dividend (which is excess earnings of the company that are paid out to the shareholders based on their stock ownership).

This is in contrast to an S Corporation, where the incentive exists for a shareholder to take as low a wage as possible to avoid employment taxes. The S corporation does not pay income tax on earnings. This income is passed through to the stockholder and taxed with their other income. Since wages and dividends are combined with the other income of an S corporation shareholder and the resulting tax calculated on the whole, the payment of employment taxes on wages is an additional tax that can be avoided by just taking a dividend on the earnings of the company rather than taking any wages. Thus, the IRS attacks the issue of "reasonable compensation" from different sides for C Corporations and S Corporations.

The issue of reasonable compensation is frequently the subject of litigation between taxpayers and the IRS. There are no specific guidelines in the Code or regulations on which the courts can rely, so the determinations are based on the facts and circumstances on a case-by-case basis.

What is reasonable compensation?

Courts rely heavily on whether wages are similar to what an unrelated investor would pay the employee for the same work. A compensation package will withstand IRS scrutiny if it represents the amount that would be paid in an arms-length transaction. Average salaries for many jobs categories based on geographical locations can be found on the Internet at www.salary.com.

In July 2002, the Treasury Inspector General for Tax Administration issued a report that revealed substantial noncompliance among S Corporations with regard to reasonable compensation for corporate officers. The report recommended that the IRS aggressively pursue whether distributions to corporate officers represented reasonable compensation for services.

In stark illustration of the increased scrutiny of compensation for S Corporation shareholders, the Tax Court mowed down six S Corporations in one day, recharacterizing distributions to shareholders as wages. This occurred in February 2003 and all six corporations were in blatant violation in that they were not reporting any wages for corporate shareholders performing services. The decisions were referred to in the Federal Tax Bulletin in an article entitled Tax Preparer Can't Avoid Employment Taxes by Forming an S Corporation. The bulletin referred to the Tax Court's determination that an S Corporation cannot avoid employment taxes by characterizing compensation paid to shareholders as a distribution of net income. The Supreme Court refused to hear the cases.

Other Factors

Other factors that you should consider in evaluating the reasonableness of your compensation and tax minimization strategy include the frequency that you take dividends from your S corporation. Do you actually do an evaluation of the business fundamentals before declaring the dividend? As a stockholder, do you have sufficient income from other sources to support your lifestyle (this would not be controlling as it is reasonable for you to receive a return on your investment regardless if you are the majority stockholder or not?) As previously noted, the reasonableness of compensation for an S corporation employee/stockholder is evaluated from a different perspective of the same individual with a similar ownership/employee situation of a C corporation. You should not ignore the opportunities to minimize your overall tax obligations, but you must evaluate your approach as if you anticipated that the IRS would conduct an audit and question the reasonableness.

Mike Roberts, C.P.A., thoroughly understands the financial side of the pizza business. He has worked with hundreds of pizza business clients since the 1980's.