Steve A Porter, CPA

There has been a lot of talk lately about compensation. Executive bonuses, compensations limitations, disparity of compensation. Often it is in the context of political ideology, or basic fairness. But if you ask ten people what is a reasonable compensation for a given job, chances are you will get ten different answers.

Most of the issues you hear being discussed lately concern an unreasonably high compensation, but if you are a business owner and you are actively involved in your business, a compensation that is unreasonably low can have special significance under scrutiny of an IRS auditor.

Let’s look at a very common scenario. A bright, entrepreneurially minded person decides to start a business. Upon advice from that person’s attorney and CPA, the business is set up as a Sub-chapter “S” corporation, (usually referred to as an “S-Corp”). As a start up, the business owner decides not to take a salary, or decides to take only a small token salary until the business becomes profitable and begins generating cash.

This new business owner works countless hours, and after a lot of hard work, begins to see the fruits of his/her labor in the form of profits. Since the company is an S-Corp, these profits can be taken from the business without paying taxes on the distributions (in contrast to a C-Corp where dividends would be taxable). And these distributions, unlike wages and compensation, avoid FICA, Medicare, and in some cases local occupational taxes, so the owner sees no need in increasing his/her salary.

Seems like a no-brainer, doesn’t it? Instead of increasing the salary, just take the earnings out as distributions and avoid 15.3% in payroll taxes (7.65% paid by employee matched by employer, subject to a ceiling).

Not so fast…here’s where the IRS becomes interested in reasonable compensation.

You see, you have to pay yourself a reasonable compensation, or else the IRS can deem a portion of the distributions you take from your company wages, subject to FICA/Medicare taxes. And to make things worse, you will be levied for fines and penalties on unpaid payroll taxes, these fines and penalties being among the most punitive in the tax code.

Unfortunately, there is no safe harbor, nor is there a table where you can look up an amount which would be considered reasonable compensation. Just like the current debates about executive pay, there is an element of subjectivity in what is considered reasonable by the IRS. I always tell my clients to at least try to come up with an objective basis in determining what there salary is. There are online sites which can provide guidance, not to mention wage and salary surveys in certain geographical areas. I cannot emphasize too much the value of documentation. Formulate an objective basis of your salary (and bonus if applicable), keep written documentation on how you arrived at your salary, and be consistent. Avoid “changing the rules” from one year to the next due to business conditions, and if you feel justified in making changes in the rationale behind your salary, document it!

Note, this article deals with the reasonableness of salaries or owners in S-Corps where generally smaller is better. C-Corps have a different set if circumstances which I will be taking a look at in future articles.

Written by Steve A. Porter, CPA, CMA

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