What is reasonable compensation?

Reasonableness of compensation is an even more important issue after the Jobs and Growth Tax Relief Reconciliation Act of 2003's changes in the taxation of dividends. The IRS has long tried to reduce the compensation of C corporation owners (because it is deductible) and increase the compensation of S corporation owners (because it is taxable). With the new 15% dividend tax rate, many C owners may be tempted to reduce their compensation and take the rest of their income as a dividend. Is this wise?

Intent Test

In determining whether compensation is reasonable, there are two hurdles: the "intent" test and the "amount" test. The intent test is the easier of the two to pass. By paying an individual, the intent was to pay for services; by not paying, the intent was to keep the money to grow the business. However, when a payment is later recharacterized (from salary to a distribution, for example), the intent test may be difficult to pass.

Amount Test

The amount test has received the close attention of the IRS and business owners alike. Regs. Sec. 1.162 7(b)(3) states: "It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances." Or, in other words, if a business were hiring someone to perform the same services, how much compensation would be paid in an arm's-length transaction? In making that determination, (1) the employee's qualifications, (2) the employee's contribution to the business's success, (3) how tire employee's salary compares to the salary scale of employees generally and (4) how the employee's salary compares to the salary scale of the industry, should all be considered.

Contingent Compensation

Many companies, particularly professional corporations, pay year-end bonuses that substantially reduce the business's taxable income. Although contingent compensation arrangements are often an indispensable part of the business world, they are subject to special scrutiny in closely held corporations, Regs. Sec. 1.162-7(b)(2) states:

Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.

Establishing a reasonable compensation level is a not a science, especially when it includes a contingent compensation arrangement in a closely held corporation. However, although the Service generally litigates only in extreme cases, a taxpayer has the burden of overcoming the IRS's determination of "reasonable" compensation. Thus, it is important to document the facts and circumstances of the compensation decision.

Conclusion

No set of equations yields the correct amount of compensation to pay. it is always safest to pay an owner-employee near a market salary. In addition, a C corporation owner who reduces salary and pays a dividend will not save much money, unless the corporate change in income does not push its taxable income past the 15% bracket. Because the corporation cannot deduct the dividend paid, but can deduct compensation, the overall tax savings (corporation + owner) will not be as great as may be anticipated.

FROM THOMAS SWAPP, CPA, BROWN, DAKES, WANNALL & MAXFIELD, P.C., FAIRFAX, VA

Allen M. Beck, CPA, MST 

Tax Manager

Ehrenkrantz sterling & Co., L.L.C.,

DFK International

Livingston, NJ