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Let’s Be Reasonable…

Has your CPA had a compensation discussion with you recently? Did they infer that your compensation is “unreasonable”? Don’t take offense. It’s not personal. But as a business owner, paying yourself a salary that aligns with the general marketplace is essential. After all, if your compensation is deemed out of line, the IRS could get suspicious, and your compensation deduction could be denied.

What you need to know about reasonable compensation.

The IRS states that reasonable compensation is “the value that would ordinarily be paid for like services by like enterprises under like circumstances.” ~ IRS Code: Section 162-7(b)(3)

Compensation must be viewed through the lens of “valuation,” the hypothetical replacement cost of a business’s owner or key manager.

There are two points to consider.

How much compensation would be paid for this position if a non-owner held it in a typical employment relationship at a similar company?

Or…What would you be paid if you were to close your own firm and work for a competitor in the same field, performing the same services?

The IRS is on to the game that some business owners have played over the years—that is, attempting to drive their compensation either up or down for perceived benefits or tax advantages. And, if you try to convince them that you deserve a higher salary because you are so outstanding in your field–well, that won’t fly, either.

Let’s say you are a business owner who wears many hats and works 60+ hours per week—but you only pay yourself $25,000 a year. Take some time to review your own job description and then consider this: would anyone else would take on the sales, bookkeeping, production, logistics, and everything else you manage for $25,000? If the answer is a flat-out “no way,” you’ve answered your own question. You are not being reasonably compensated.

Here’s another example. If your very successful business earns $50 million a year in revenue, is it reasonable to pay yourself $7 million annually? You may think you deserve it, but if you were unable to work for a year and needed to pay someone to take your place, would you be writing them a check for $7 mil? I think not. You’re being a bit unreasonable.

It’s a touchy subject.

Reasonable compensation has been a touchy point with the IRS—especially with small, family-owned businesses for two reasons:

  1. The “employee” has some control over the business (e.g., as “stockholder”)
  2. The “employee” has a personal relationship with the owners.

In these situations, the IRS will closely scrutinize the payments—and most small businesses fall squarely into these categories. Here’s the perfect example: Paying your 12-year-old son $7.50/hour for general janitorial services at the office is legitimate, but paying him $75.00/hour would undoubtedly raise a red flag.

Clearly, these factors are open to interpretation, and the IRS and the taxpayer frequently have very different views of “reasonable.” More courts are framing the issue this way: “Would a completely independent investor in the company be willing to pay that level of compensation to this individual?”

All compensation that you receive should be in line with:

  • your personal credentials,
  • compensation paid to non-shareholding employees,
  • your degree of involvement in generating corporate income,
  • the type of work you perform, and
  • the prevailing local rate of compensation for similar expertise and work.

Keep your compensation in line with the rest of the world. If it’s too high or too low, it’s bound to get a closer look (and possibly adverse consequences) from the IRS. Typically, C Corporations will be scrutinized for paying principals too much because the IRS may rule that those funds should be treated as excess dividends. This can result in double taxation. S-Corps will get a second look from the IRS for paying principals too little.

Have questions about compensation?

Think of us as a member of your financial team. Give me a call if you have questions about reasonable compensation.

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