Business owners and shareholders have some leeway on their compensation structures, to a point. The IRS has long held a standard called “reasonable compensation” that it uses to determine if, like Goldilocks, you got it just right.
The trick to acing reasonable compensation, however, involves the same inherent challenge as many other IRS rules: it’s frustratingly vague. Therefore, it’s important to work with a tax professional who can “reasonably” guide you in determining what “reasonable” may be in your situation.
There are three primary types of businesses that the IRS tends to scrutinize when it comes to reasonable compensation: C corporations (C-corps), exempt (nonprofit) organizations, and S corporations (S-corps).
When C-corp employee-owner/shareholder compensation catches IRS ire, the question at hand is often whether that compensation is too high. The IRS will often scrutinize the use of dividends (the distribution of corporate earnings) versus compensation (payment for work). C-corps can deduct salaries and bonuses paid to employees, but they can’t deduct dividends, which leads to dividends essentially being “taxed twice” (at the corporate level and then again at the personal level). Excessive compensation may trigger a closer look at whether some of that money in the form of salaries and bonuses is really disguised dividends that should be taxed (the IRS is known to recharacterize this income).
Nonprofits are also scrutinized in this area for over-compensation of key executives. To maintain nonprofit status, the organization must be able to prove that its executive compensations are “reasonable and not excessive” based on “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
Whether you’re a compensated nonprofit executive yourself or a nonprofit board member who is a part of compensation decisions, it’s important to note that a hefty 21% excise tax may come into play if it’s determined that the tax-exempt organization’s executive compensation is excessive. Board members that approved the compensation may also be affected.
S-corps, on the other hand, are often scrutinized for under-compensation. In this structure, business owners are usually classified as shareholder-employees; their compensation incurs payroll taxes, while their profit distributions do not. The IRS requires S-corps to pay reasonable compensation to a shareholder-employee in return for services before non-wage distributions are paid.
This is where the Goldilocks analogy really comes into play. If you’re an S-corp business owner, you may have heard about rules of thumb like the “60-40 rule” (paying yourself 60% on payroll and 40% through distribution) or the “50-50 rule” (50% payroll, 50% distribution) to meet this reasonable compensation requirement. It’s important to note that while these approaches may do the trick, they’re rather arbitrary “guesses” on what will make the IRS happy. The IRS reserves the right to reclassify payments made to shareholders from non-wage, tax-free distributions to wages subject to employment taxes.
Bonuses, benefits, loans to shareholders, and other factors can complicate compensation as well, which means it’s well worth getting a professional opinion about how you’re paying yourself. Feel free to contact us with questions.