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Avoiding unreasonable compensation.

The builder works 80-hour weeks for three years to build the business, leaving all the money in the company. Finally, the company is on solid ground, and the builder rewards himself with a hefty compensation package, in effect taking four years of salary. in one year. On the surface that seems fair, but in the eyes of the Internal Revenue Service, it might be unreasonable compensation, opening up the builder to back taxes plus penalties and fines.

What constitutes unreasonable compensation? "Unfortunately, the IRS has not designed a specific test or a convenient chart of salaries to determine reasonableness," says Jeffrey Rogers, a CPA at Aronson, Fetridge & Weigle in Rockville, Md. "Each case is determined by all.the facts and circumstances."

Rogers says that unreasonable compensation can take many forms. One of the most common is a builder pulling accumulated earnings out of the company, which the IRS might classify as excess accumulated earnings and subject to an accumulated earnings tax. Rather than take the earnings as dividends, which aren't deductible, the builder increases the deductible owner compensation. "Doing so," says Rogers, "can leave contractors open to IRS scrutiny."

To establish reasonable compensation, Rogers recommends taking four steps:

Analyze your current compensation plan. Rogers advises looking at recent court rulings to help analyze a plan (see box, right).

Revise the plan. Rogers recommends putting all salary and bonus agreements in writing, describing each position and role in detail, maintaining corporate minute books, and establishing deferred-compensation packages.

Consider S corporation status. "In an S corp, earnings are taxed to the individual shareholders rather than the corporation," says Rogers.

Make periodic dividends. Paying small dividends throughout the year helps prevent IRS action, because the builder isn't trying to distribute all the earnings through compensation.

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Author:Donohue, Gerry
Date:Oct 1, 1997
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