The reasonableness of shareholder/employee compensation is an important – and often controversial – income tax consideration for closely held corporations. This is particularly true for the closely held corporation structured as either a C corporation or an S corporation.
For a C corporation, the IRS is typically concerned with an unreasonably high (or excessive) level of employee compensation. In such cases, the Service often claims that the excess employee compensation absorbs taxable income and represents a disguised dividend to the shareholder/employee.
When dealing with compensation, the rules allowed for a deduction in “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business include a reasonable allowance for salaries or other compensation for personal services actually rendered,” according to Code Section 162. The Service juxtaposes this by stating that “the test of deductibility in the case of compensation payments is as to whether they are in fact purely payments for services.”
Both the IRS and the courts tend to focus on whether the compensation of a closely held C corporation shareholder is ripe for the services the shareholder performs. This focus is driven because if the compensation paid to the shareholder is not reasonable, it generally would be presumed that a portion of the payments is not for services rendered.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.