Paying “reasonable compensation” to key employees

As the owner of a business, it is your responsibility to know if you are paying your employees a fair salary in the eyes of the Internal Revenue Service.

art_paycheck For many types of businesses, the IRS critically views certain employees’ salaries as a means for the business to evade tax, and it will remedy the situation with additional tax, penalties, and interest when they view this to have occurred.

What is the IRS is seeking when they audit a business for reasonable compensation, and how can you determine what salary level is reasonable enough to pass IRS inspection? The answers to these questions depend on the type of business involved and the details related to the employee’s duties and compensation.

What is the IRS Looking For?

The three types of businesses that are most likely to be audited by the IRS for unreasonable compensation are listed below. For each, we’ll share what the IRS is looking to find during an audit and what assessments will be made against a business that fails the reasonable compensation test.

Closely-held C Corporations – Closely-held C corporations are at risk of overpaying their shareholder-employees.

C corporations may only deduct compensation for what is “reasonable” for their employees who are also shareholders. Compensation of non-shareholder employees is generally of no consequence and will not be questioned by the IRS.

In an ideal world, C corporations would choose to increase the salaries made to their shareholder-employees. This would allow the organization to take a larger salary deduction, thereby reducing taxable income for the business. Unfortunately, the IRS recognizes this act to be a “disguised dividend” and will disallow the deduction for the amount above what is considered reasonable. This increase in income would result in more tax, and the IRS would likely also apply penalties and interest.

S Corporations – S corporations are at risk of underpaying their shareholder-employees.

Differing from C corporations, S corporations run the risk of underpaying their shareholder-employees. Ideally, S corporations would prefer to pay their shareholder-employees a lower salary to reduce their payroll tax liability, and instead have a larger shareholder distribution at the end of the year. These distributions typically are not taxed. The IRS states that S corporations, like C corporations, are expected to pay reasonable compensation to their shareholder-employees. Therefore, these excess distributions could be reclassified as salary expense and be subject to payroll and employment taxes, as well as penalties and interest.

Not-for-profits – Not-for-profits are at risk of overpaying their key employees.

Many not-for-profit organizations have such small or closely-held operations that certain key employees are able to set their own salaries. To mitigate this potential abuse of authority, the IRS imposes an excise tax on any key employee of a not-for-profit who is found to have unreasonably high compensation. This tax is also imposed on the organization’s managers who approve such a high salary, assuming their participation in the scheme is willful. The excise tax to the key employee is 25% of the excess compensation, and the excise tax to the organization’s managers is 10% of the excess compensation. This tax is not imposed upon the organization, but upon the employee and managers themselves.

What exactly is “reasonable compensation?”

Now that you know what the IRS is looking for, you will need to know how to determine a reasonable salary for each of your key employees. First, keep in mind that this “reasonable compensation” requirement only applies to shareholders who are performing some sort of business function, or to key employees of a not-for-profit.

The first question you should ask yourself is, “is this person truly an employee?” If this person is performing substantial business duties for the business, they would be classified as an employee. Performing minor services throughout the year does not classify the shareholder as an employee. Once you have made the employee determination, you can move on to see if the compensation he or she is receiving is reasonable.

To determine if the shareholder-employee or not-for-profit key employee is receiving reasonable compensation, some questions you can ask yourself are:

What is the scope of the employee’s duties?
Is the employee qualified to do the job he/she is performing?
How much time does the employee spend performing his/her duties?
What salary would an outside hire expect to receive to perform this business function? Public libraries usually have reference materials that provide average compensation levels for various types of services.
Is the employee’s salary in alignment with the compensation of his/her subordinates and peers?
Is the compensation reflective of business growth?
Does this employee’s particular business function generate revenue directly? If so, is the salary commensurate with his/her performance?
Does this person’s salary align with the organization’s salary policy for all other employees? For example, some businesses require anyone with a bachelor’s degree to receive $X compensation, or anyone with more than five years of relevant experience to receive $Y compensation.

There is no exact answer for what is reasonable or unreasonable compensation, and it is impossible to guess the exact salary the IRS would assign to the employee-shareholder’s job function. However, if you answer the above questions honestly, the salary you determine should be rational enough to pass the IRS’ reasonable compensation test.

If you are unsure if you are paying your employees a reasonable salary and would like help in determining what it would be, please contact your WK advisor at (573) 442-6171 or (573) 635-6196.

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Paying “reasonable compensation” to key employees