Is Your Client’s Officer Compensation Reasonable?
When the economy changed and tax revenues declined, Congress and the US Treasury Department put pressure on the IRS to generate additional tax revenues. The results? The IRS issued its opinion regarding higher audit enforcement.
One of the areas of high enforcement is officer compensation for shareholders of Subchapter S corporations - and this topic is on the IRS hot list. Oftentimes, people misinterpret the Internal Revenue Code (IRC) and Treasury regulations. The code and regulations are vague and don't clearly define reasonable compensation for shareholders. In other instances, shareholders of S corporations abuse the law in order to generate a tax-savings benefit. The consequences of misinterpretation or abuse of the law can be quite costly if a business gets under audit for reasonable officer compensation. The liability can add up to be as much as two to three times what would have been due originally - had reasonable compensation been paid.
Although the IRC does not define what constitutes reasonable officer compensation, it does state that shareholders of S corporations are included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act), and federal income tax withholding. The law requires corporate officers (shareholders) who perform services for the corporation and receive or are entitled to receive payments to have their compensation considered as wages.
In addition, courts have consistently held that officers/shareholders of S corporations who provide more than minor services to their corporation and receive or are entitled to receive compensation are considered employees, and the payment is considered taxable for federal employment tax purposes.
If this is the case, then why is the law vague as it relates to reasonable compensation? The more the gray area in tax law, the easier it is for the IRS to increase audit enforcement and generate new tax revenues during a challenging economic environment - such as the one that we are currently experiencing.
Because there are no specific guidelines for reasonable officer compensation outlined in the IRC or the Treasury regulations, audits can be reviewed on a case-by-case basis. It is difficult for the IRS to use one case as precedence for future cases because no two business owners operate their business in an identical manner, and no two officers allocate the same number of hours or contribute the same services to their corporation. No two businesses generate the same revenues, so what is reasonable for one business to pay its shareholders may not be reasonable for the other.
The courts that have ruled on reasonable officer compensation cases based their determinations on the facts and circumstances of each case. Nine factors the courts considered in providing rulings for reasonable compensation cases include:
- Duties and responsibilities of the shareholder.
- The time and effort the shareholder devotes to the business.
- Training and experience of the shareholder.
- What comparable businesses in the industry pay for similar services.
- Dividend history.
- Payments provided to nonshareholder employees.
- Compensation agreements.
- The timing and manner of paying bonuses to key people in the corporation.
- Any formula used to determine compensation.
In addition, the IRS will consider fringe benefits paid to shareholders as compensation in a reasonable officer compensation audit. For example, health insurance premiums paid on behalf of greater than 2 percent of shareholders of S corporations are considered fringe benefits that are reportable as wages for federal income tax withholding purposes on the shareholders' W-2, but are not subject to Social Security and Medicare (FICA) and federal unemployment taxes. There are other fringe benefits that can be considered income; however, health insurance is the hottest one currently for Congress and the IRS.
I have had the great fortune to have favorable outcomes in officer compensation audits that I have represented. They don't all conclude with positive outcomes for our clients, but it does make our job easier in representing reasonable officer compensation examinations when our clients maintain accurate and detailed recordkeeping that we can use to justify why the officer compensation paid was reasonable. Due to the current economic and political landscape, we should expect to see a substantial increase in reasonable compensation audits. This topic is, and will continue to be, on the forefront of the IRS hot audit list.
I highly recommend that you consult with your clients to review their policies, procedures, and recordkeeping, and help them identify what is reasonable for their industry and the services they provide to their corporation. What was reasonable several years ago may not be reasonable today. Perhaps the compensation they paid themselves prior to the recession is too high in today's marketplace - or maybe not enough if they were not paying reasonable compensation from the get-go.
As the economic and political environment changes, we must also help our clients adapt and make changes that will help them better manage their business and provide some audit protection. Whether this boils down to making changes to officer compensation, providing new avenues for tax savings, or simply maintaining better records, we are the professionals who our clients rely on to provide good guidance within the law.
Prepare your clients for a potential reasonable officer compensation audit that may come knocking on their door.
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Andrew G. Poulos, EA, ABA, ATP, is principal of Poulos Accounting & Consulting Inc. in Atlanta, where he works with individual and business tax clients, and represents clients before the IRS and state labor agencies. A self-made entrepreneur and real-estate investor, Andrew is an author, national speaker, and nationally syndicated tax...