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Articles • 05/23/2023

Avoiding IRS Challenges with Business Owner Compensation

Operating a family-owned or closely held business requires owners to make decisions with significant tax consequences. One example involves the compensation business owners pay themselves and whether those amounts are reasonable and deductible as “ordinary and necessary” business expenses. The answer can depend, in large part, on how the business is structured.

Generally, employers must withhold and pay federal income tax, Social Security and Medicare taxes on employee wages. Such compensation may also be considered ordinary and necessary business expenses that employers may deduct from their taxable income when the amounts are deemed “reasonable” and paid to employees for services actually rendered.

What is Reasonable Compensation?

The Tax Code defines reasonable compensation as that which a like business in the same circumstances would pay for similar services. In this sense, reasonable compensation refers not only to the amount paid to the employee but also to the following considerations:

  • the nature, extent and scope of the employee’s role in the company;
  • the employee’s qualifications, expertise and previous earning capacity;
  • the time the employee devotes to the business;
  • the company’s compensation policy;
  • the size, complexity and financial condition of the business;
  • the prevailing general economic conditions; and
  • the going rate of compensation similar businesses and industries pay to employees in comparable positions

No one factor carries more weight than another. Instead, determining reasonable compensation is based on an interpretation of facts, which businesses should document carefully to stand up to IRS scrutiny.

These factors apply when determining the reasonableness of compensation businesses pay to their owners, shareholders and related parties (i.e., spouse or children) for services performed on behalf of a company. According to the IRS, owners and shareholders who contribute time and services to their business are considered employees who must receive reasonable compensation in the form of W-2 wages that correlates with their duties. Such compensation is subject to payroll taxes and deductible as a business expense, for which many businesses get into trouble based on their tax structure. More specifically, the IRS wants to ensure that salary and wages paid to owners are associated with actual services performed and that amounts paid are neither insufficient nor excessive, which can depend on the business’s entity structure.

S Corporations

Reasonable compensation issues with S corporations typically occur when wages paid to a shareholder/employee are below industry standards or less than the amount comparable businesses pay workers for similar services. By keeping shareholder/employee compensation low, the company can minimize its state and federal payroll and unemployment tax liabilities and instead make tax-free distributions of company profits to shareholders. Alternatively, an S corporation may raise compensation to family member employees as an ordinary and necessary business expense to receive a higher tax deduction for those amounts while also allowing the family to transfer wealth to future generations free of gift and estate tax.

The IRS, which looks out for substantial shareholder distributions, has the authority to reclassify non-wage distribution to wages subject to employment taxes.

C Corporations

C corporations are legal entities treated as separate from their shareholders and subject to two layers of taxation. In other words, these companies first pay corporate taxes on their earnings and then pass after-tax profits to shareholders/owners as dividends, which are treated as taxable income to the shareholders/owners and, therefore, do not qualify as deductible business expenses. Consequently, C corporations may pay shareholders/employees a higher-than-standard compensation to maximize their deductible expenses and avoid federal and state taxation at the corporate level. However, should the IRS deem an employee’s/shareholder’s salary excessive, it may treat the unwarranted portion of that salary as a nondeductible distribution of earnings to the employee/shareholder.

Business owners must take the time to understand the rules for paying themselves reasonable compensation to avoid falling into the IRS’s crosshairs. The amount paid must correlate to the actual performance of services and be analyzed to ensure it is neither inflated nor understated to minimize or avoid tax liabilities.

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