What is Reasonable Compensation and Why Closely Held Business Owners Should Be Concerned

This is a big issue with the IRS and closely held C corporations right now.  The focus is whether or not the owners-employees, as well as family members, are reducing their profits through large salaries and bonuses.

The IRS wants to know if these payments are really dividends, thus a non-deductible expense of the corporation.  In a recent decision, the tax court determined five factors in deciding whether the amount of compensation paid to the owner was reasonable.  The factors are:

  1. The employee’s role in the company.
  2. An external comparison with other companies in that industry.
  3. The character and condition of the company.
  4. Potential conflicts of interest.
  5. Internal consistency of compensation.

Taking a brief look at these five factors, the shareholder’s role in the company would be of significant importance when determining compensation levels.  How much time is devoted to the company’s operations and is the success of the company directly related to the owner?  The courts are most definitely going to compare compensation with that paid to other shareholders within that industry.  And at the same time, they will look at the character and condition of the company.
Consideration will be focused on sales, net income, capital value and how successful the company is.  Conflict of interest is basically examining the relationship between the shareholder-employee and the company.  Because of this relationship, more scrutiny may be warranted and in turn, there will be more emphasis on profit percentages and rates of return on equity.  Consistency in these rates over several periods is important.

Finally, does the company have a policy for paying compensation and bonuses?  Are salaries based on profits, and is there a written compensation plan?  Unreasonable compensation in closely-held corporations will be a red flag to the IRS.  Be consistent.

ACTION ITEM:  Reasonable compensation is a big issue with the IRS right now.  Know the factors that go into this analysis and document all major decisions about compensation to owner-employees and their family members.

Thomas F. Scanlon, CPA, CFP ®

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2 comments on “What is Reasonable Compensation and Why Closely Held Business Owners Should Be Concerned
  1. This is a well thought out article that I have bookmarked for future reference.

  2. Fred Smith says:

    Saved, I really like your site!