Establishing Reasonable Compensation         

We've seen it before.  A successful entrepreneur (let's call him Dave) starts his own company and after a few years of blood, sweat, toil and tears, he begins to reap the rewards in the form of a million dollar salary and vacations in Bermuda.  It's another one of those fairy tale endings that we often see with our hard-working clients - until the dreaded notice arrives in the mail.  Dear old Uncle Sam wants to take a quick look at Dave's books!


Dave, being a hard working and honest fellow, assumes he has nothing at all to worry about.  His records are meticulous.  His travel and entertainment is conservative and carefully documented.  He welcomes the IRS agent into his office with a warm smile and open arms and then flies off to Bermuda once more fully content with his fairly tale world. 

Basically, the IRS allows for a "reasonable allowance for salaries or other compensation for personal services actually rendered." 


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."  

What is "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 corporation.  

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."  

Dave 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" employee?

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 company?

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 not.  

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 compensation.

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 happened.  

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.