Unfortunately, the next chapter in this story begins with a
stunned Dave screaming at his startled wife and children that the IRS is
planning to bankrupt them.
It seems that poor Dave has come face to
face with the "reasonable compensation" rules included in the
Tax Code. Basically, the IRS allows for a "reasonable allowance for salaries or other
compensation for personal services actually rendered."
"reasonable" you ask? Good question. In this
(fictional) case, the IRS has told Dave that $1,000,000 per year in salary
is not reasonable for his small company and that he should have taken most
of that salary in the form of a dividend from his solely-owned
But wait, you say! Whether Dave takes his
rewards in the form of dividends or salary, it should make no difference - both
are taxable! Yes, that's true, but there is an important distinction
between dividends and salary. Salaries are deductible by the corporation and
dividends are not. The IRS expects corporations to pay their employees
(including owner-employees) a "reasonable" salary and pay out any
excess profits to the owners as non-deductible dividends.
Dave, unfortunately, paid out ALL of his
company's profits as compensation to himself. If he had not, his company
would have paid taxes on its profits and then Dave would have paid taxes again
on the dividends - hence, the dreaded "double-taxation."
thought he was being smart by paying out all profits as a year-end bonus to
himself. If his corporation had paid out the profits as dividends, his
total tax bill (between himself and his wholly-owned corporation) would have
been a couple hundred thousand dollars higher.
Considerations Of Reasonable Compensation
So, what exactly IS reasonable
compensation? This area of tax law has been contentious for many
years and the courts have established some precedents that we can
look to for guidance:
Is the person involved a "key"
Generally, the answer to this question is
yes. In our case above, Dave is the sole owner and is mostly
responsible for the company's success. However, in some cases of
excess compensation, the owner is little more than a figurehead who
actually does little for the company, but takes an exorbitant salary
simply because of ownership.
What is the general condition of the
Is the company profitable? Are its
sales and profits increasing or remaining stable. If you have a
company that is on a major growth spurt, it can signify that any outside
investors might consider the future potential of the stock to be of
greater value than any short-term profits. Independent investors
might be willing to sacrifice short-term profits to pay higher salaries to
key employees responsible for that growth.
How does the compensation compare to
similar companies in the industry?
Again, if the company is in a
"hot" growth industry, the tax court may find that other similar
companies are also paying their chief executives tremendous
salaries. If your company is unique in some way from its
competitors, there may be a reason that it would pay a higher
salary. The courts have considered this aspect in the past.
How was the compensation determined and
is it applied consistently?
Is there an established formula for
determining compensation and has it been applied consistently over several
years? In Dave's case above, it may be clear to the court that he
was simply paying out all of his profits to avoid double taxation.
However, if you can establish that your compensation plan is based on a
valid business formula and has not varied from year to year, your case may
well be strengthened.
How would an outside and independent
investor view the compensation?
This test is generally the one that sinks
most cases for owner/employees. Would an independent investor buy
stock in the company with its current compensation arrangement? In
Dave's case above, I think we can all agree that the answer is probably
Unless Dave brings some special skill or talent to the company
that is irreplaceable, most small independent companies would not pay him
$1 million annually. An independent investor is unlikely to want
stock in a company that pays all of its profits to its CEO as
There are always other extenuating factors that
play into almost every case, but we can assure you that the major topics
outlined above will be considered by both the IRS and a Tax Court hearing.
Most cases are probably settled out of court in some type of compromise, but to
be honest, the situation we described above with Dave never should have
If Dave had sat down with us a few years ago, we could have
explained the issue of reasonable compensation to him and discussed his
alternatives. Establishing his company as an S Corporation (which
automatically distributes all earnings to the shareholders) would probably have
been his best alternative, but as so often happens, poor planning in advance can
cost you dearly down the road.