Is your compensation reasonable? That is for tax purposes

There are two universal principles regarding the fairness of employee compensation: (i) most people feel that they are undercompensated and (ii) the same people feel that their friends and neighbors are overcompensated. There are many reasons for this phenomenon, but for our unscientific purposes it is sufficient to think of fairness as beauty – it is in the eye of the beholder.

The tax world is no different, except that the incentives to determine how “fair” a return is are different. The exact tax incentive depends on the type of entity and the tax involved.

For starters, the concept of fair compensation does not apply to businesses operating as partnerships or sole proprietorships because partners and sole proprietors are not considered employees and do not receive a W-2 wage statement. Instead, partnership and sole proprietorship earnings are subject to federal income and self-employment taxes, regardless of how they are earned.

The concept of fair compensation comes into play with C corporations and S corporations, and then almost exclusively with respect to compensation paid to business owners. In some circumstances, taxpayers are better off tax-wise if they pay higher salaries to shareholder-employees; In others, they are better off paying less. 

This creates an interesting tension between taxpayers and the IRS because they end up on both sides of the fair compensation issue, which is unusual in the area of ​​taxation. Generally, the IRS is expected to position and argue against taxpayers. For example, taxpayers often deduct items that the IRS disallows, but the IRS generally does not argue that taxpayers should deduct expenses they did not deduct. with reasonable compensation,

Let’s see why this is so.

C corporations cannot deduct more than “reasonable allowances for salaries and other compensation for personal services.” (There are additional limits on publicly traded corporations that are not discussed here.) These are considered a normal and necessary business expense, and the amount that is considered “reasonable” serves as an upper limit to the amount that can be deducted. Is – Anything beyond such amount is called lavish or extravagance. 

Thus, if the IRS challenges a taxpayer’s deductions for compensation (which includes regular pay and bonuses) as unreasonable, it will argue that the amount paid exceeds what is normal and necessary. Note that the IRS will not challenge a taxpayer’s ability to pay its employees what it wants; Instead, the IRS will argue that the “unreasonable” portion of the compensation is not tax deductible.

With S corporations, wage fairness usually serves as a floor – a minimum amount that is required to prevent the distribution of earnings into wages. If the IRS were to challenge the S corporation’s deduction for compensation as unreasonable, it would argue that the amount paid was insufficient, and that the distribution of the taxpayer’s earnings was actually a disguised payment of wages, and therefore subject to employment tax. Let’s see why this is so.

S corporations offer pass-through taxation, that is, a level of taxation at the shareholder level. This is more favorable than C corporation taxation, which involves two levels of taxation – once at the entity level and once at the shareholder level when profits are distributed. 

The tradeoff for the favorable tax treatment afforded to an S corporation is that it is subject to restrictive qualification requirements, such as: (i) it must be a domestic corporation, (ii) its shareholders must be individuals or specific trusts or estates – partnerships, corporations or nonresident aliens, (iii) it cannot have more than 100 shareholders, (iv) it can have only one class of stock, and (v) it cannot be a disqualified corporation such as a financial institution or insurance company.

Employment tax

Many businesses that choose S corporation status do so because of the ability to reduce employment taxes on earnings distributed to the business owner(s). Employment tax applies to wages paid to employees, including shareholders, working in the business, but not to distributions of earnings to shareholders.

Consider a profitable business that earns $3 million a year for its sole or principal shareholder. If $3M is paid to a shareholder in the form of a salary or bonus, the employment tax applicable to the S corporation and employee would be approximately $130,428, including a 12.4% Social Security tax on wages up to $147,000, a 2.9% Medicare tax on all wages, and $200,000 and over. An additional Medicare tax of 0.9% on higher wages (we ignore the Federal Unemployment Tax on Employers (FUTA) because the amount is negligible).

If, however, the S corporation limits compensation expenses to $1M instead of $3M and calls the other $2M a distribution of earnings, the employment taxes applicable to the S corporation and the employee total $54,428, netting the S corporation/shareholder economic unit in tax savings at the federal level. About $76,000. There will also be state employment tax savings.

If you’re still paying attention, then you’re probably asking yourself why not just reduce the return to zero and call the entire $3M a distribution from the S corporation and avoid employment taxes entirely? While that works from a mathematical perspective, it doesn’t work from a tax perspective. How do we know that? Because the IRS said so in 1974 when it issued Revenue Ruling 74-44 to reclassify dividends paid as wages instead of wages. 

Moreover, courts have regularly held that when an officer or shareholder renders more than minor services to a corporation, and receives or is entitled to receive payment, such person is an employee of the corporation and is subject to federal employment taxes. Treasury and the IRS also reiterated this rule in the rules, and the rules apply even if the parties designate the payment as something other than wages. Labels are abstract in this context.

So what is a reasonable allowance for compensation? To begin with, the IRS provides no clear guidance on the point – no ranges, no safe harbors, no rules of thumb, although it did publish a fact sheet and job aid in 2008 for IRS appraisal professionals in 2014. 

Although some may be tempted to fault the IRS for not issuing clear guidance, more likely its silence reflects recognition of the fact that justification is very fact sensitive and that what is reasonable in one context may be unreasonable in another. 

Fortunately, courts have filled this gap by developing a list of factors to consider: (i) training and experience, (ii) duties and responsibilities, (iii) time and effort devoted to the business, (iv) dividend history, (v) ) non-shareholder Paying employees, (vi) the timing and manner of paying bonuses to key people, (vii) what comparable businesses pay for similar services, (viii) compensation agreements, and (ix) the use of formulas to determine compensation.

Acknowledging that determining fairness is more art than science, some practitioners suggest a 60-40 approach as a rule of thumb – that at least 60% of the amount distributed to a shareholder should be classified as wages, and the rest can be distributed. as profit. 

This seems conservative, especially since Senator Joe Biden and his wife, according to press reports, included about 2% and 13%, respectively, of their S corporation income as wages in 2017 and 2018. In 2019, however, they increased that percentage to about 60% of their S corporation income as wages.

Other practitioners refer to comparative salary data on government websites (such as tax statistics published by the IRS), in trade publications, and on job-related websites such as or to determine average salaries for business owners. their industry. This is helpful, but it does not take into account many relevant factors such as regional differences or differences specific to the person performing the business and services.

There is usually a range of acceptable wages in any given situation, and if you find yourself in court with a reasonable compensation dispute, most likely your attorney will hire an expert witness to study compensation and the IRS will engage its own expert. The same purpose, and there will be a battle of experts.

Income tax

After the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the top tax rate applicable to C corporations is 21%. C corporations receive no deduction for dividends, and shareholders are required to pay an additional tax of 20% on their receipts. Qualified dividends plus a net investment income (NII) tax of 3.8% if their income exceeds a certain threshold. 

To reduce this tax burden, C corporation owners often try to offset the tax burden by zeroing out the corporation’s taxable income with bonus payments. Although the owner pays income and employment taxes on wage income, the corporation pays zero (or reduced) income tax and the overall tax burden is reduced.

This strategy, while effective, doesn’t always work. The IRS has the ability to thwart this by reclassifying an unreasonable portion of wages as a non-deductible dividend. 

A tax court recently considered a scenario where a business owner tried to reduce corporate taxes by dramatically increasing his salary when the business started. In Clary Hood, Inc. Vs. Commissioner, TC Memo. 2022-15 (March 2, 2022), the Tax Court rejected a corporation’s attempt to reduce its tax burden in this way, saying that a large portion of the compensation paid to the owner was unreasonable, and therefore not deductible.

In Clary Hood, the taxpayer was a C corporation owned by a husband (Mr. Hood) and wife. Mr. Hood was the CEO and ran the business. In 2014, the Corporation paid and deducted Mr. Hood’s combined salary and bonus of $1.7M, and in the following two years – the years at issue, 2015 and 2016, it deducted salary expense of $5.2M per year. Total revenue from 2014 to 2016 was $10M, $13.9M, and $22.1M, respectively, and gross income was $34.1M, $44.1M, and $68.8M, respectively.

The Tax Court analyzed the totality of the evidence in the case, including expert witness testimony, and found the setting of Mr. Hood’s compensation to be “most relevant and persuasive” through comparable concerns, the distribution history of the C corporation, and the comparable salary. The years at issue, and Mr. Hood’s involvement in the business. The court concluded that reasonable wage expense for 2015 and 2016 was $3.7M and $1.4M, respectively. As a result, the corporation was unable to deduct the “unreasonable” portion of the compensation paid to Mr. Hood and was subject to corporate tax on such amounts.

Qualified business income

After the passage of the TCJA, pass-through entities such as S corporations enjoy a 20% deduction on their qualified business income (QBI). The purpose of this deduction was to reduce the tax rate applicable to pass-through entity income as the top tax rate applicable to C corporations was reduced from 35% to 21%. The QBI deduction will disappear after 2025, although it can be extended by Congress before then.

The issue of fair compensation plays a role in the QBI calculation because S corporation shareholders are allocated a  pro-rata  share of the S corporation’s QBI and such amount is determined after deduction of fair compensation. It also plays a role in determining the amount of the QBI deduction limit which restricts the benefit of the QBI deduction in cases where the amount of the deduction exceeds a specified amount of wages paid and capital investment i.e. the so-called W-2 wage/UBIA limit.

Determining the effect of reasonable compensation on the QBI deduction is not always easy. This is because the higher the amount of wages paid, the lower the amount of the QBI deduction and the lower the amount of the W-2/UBIA limitation. Conversely, paying reduced wages results in QBI deductions and W-2/UBIA limitations.

As if that wasn’t enough, there is the Additional Business Loss (EBL) limit to consider.

Additional loss in business

The EBL limit was also enacted as part of the TCJA and was originally scheduled to expire after 2025; However, the CARES Act postponed it until the end of 2020, and the American Rescue Plan Act of 2021 extended it to 2026.

The EBL limit generally limits the ability of non-corporate taxpayers to deduct losses above a specified threshold amount; In 2022, the limit is $270,000 for single filers and $540,000 for joint filers, and these limits are adjusted annually. Specifically, the EBL limit applies to the amount by which (i) the total amount of the taxpayer’s gross income and profits attributable to such businesses (ignoring QBI deductions) exceeds (ii) the total amount of business deductions in excess of the threshold amount. Any EBL is treated as a net operating loss (NOL) carryover to the following tax year, so it is a timing provision rather than a disallowed provision.

Fair compensation affects this calculation because the higher the amount of wages paid, the lower the loss and the higher the potential EBL limit. Similarly, the lower the amount of wages paid, the less likely the EBL limit will apply.

So let’s try to put this all together using an S corporation as an example. Generally (and there are certainly exceptions), the greater the amount of wages paid to shareholder-employees, the greater the amount of employment tax, the lower the amount of QBI deductions and W-2 wage/UBIA limits, and the higher the EBL limits likely to apply. Conversely, paying a lower wage reduces employment taxes and potentially increases the QBI deduction and reduces the chances that the EBL limit will apply.

As can be seen, things get confusing very quickly. Taxpayers and practitioners alike are often confused by the issue of fair compensation. It is a sticky wicket. But with careful planning and the right tax advice, it’s an area of ​​uncertainty that can be managed.

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