Preventing A Challenge To (Un)Reasonable Compensation- CPAs Can Help Clients Stave Off IRS Scrutiny With A Little Foresight

As the IRS increases scrutiny of executive compensation, CPAs need to proactively advise their clients on how to withstand these inquiries. As a result of IRS training initiatives, three types of entities draw the most attention and therefore need good advice from CPAs.

(1) closely-held C corporations are examined to determine whether they have overpaid their shareholder-employees. These corporations are allowed to deduct only “reasonable” compensation paid to shareholder-employees. So, examiners are looking for a disguised dividend, which is corporate profit being treated as compensation. Since a dividend is not deductible, but compensation is, the IRS may treat the portion of the compensation that it considers excessive as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest, and penalties on the resulting increase in income.

(2) S corporations are audited to determine whether they have underpaid their shareholder-employees. These shareholders may have set their own pay levels unreasonably low and simultaneously increased their profit distributions. Since compensation is subject to payroll taxes, but distributions are not, some tax savings can be realized by simply reducing a shareholder’s compensation and increasing his or her distributions. But, like C corporations, S corporations are expected to pay reasonable compensation to their shareholder-employees.

(3) Not-for-profit organizations are the IRS’s third area of focus. Because key employees may be able to increase their own pay, these organizations are often audited to determine whether they have paid excess compensation. If the IRS finds that insiders have abused their authority by setting their own compensation at unreasonable levels, it will treat the payment of the unreasonable compensation as an “excess benefit transaction” subject to excise taxes under Sec. 4958. This section imposes a 25% excise tax on the recipient of the unreasonable compensation and, in addition, imposes a 10% excise tax on the organization’s managers who permitted the unreasonable compensation payment. These taxes are applied to the portion of the compensation that exceeds the amount considered reasonable. Note that both excise taxes are imposed on individuals, not the charitable organization. Therefore, CPAs should caution any charitable boards they may serve on, as well as their nonprofit clients, of the potential for personal liability.

Executives are often surprised and feel personally insulted when an IRS auditor challenges their pay. In response, they may blame their CPA for not warning them. To prevent such frustration, a few simple steps can be followed.

(1) CPAs should make sure the appropriate people are aware of this issue. Clients and their board members do not need to become compensation experts, but they should know that this is a major hot point in audits.

(2) To reduce the likelihood of such a challenge and to minimize the damage if one occurs, CPAs should advise clients to carefully document each executive’s qualifications, duties, and key accomplishments. This documentation is extremely helpful when responding to an IRS challenge.

(3) Advise clients to take time to include more than just the most apparent factors when describing an individual’s qualifications. Education and experience are obvious, but one of the most important factors may be professional goodwill, which includes reputation and relationships in the industry. Effective communication skills are another critical leadership talent sometimes left out of documentation.

(4) In making note of duties and accomplishments, clients should consider the importance of intangibles such as strategic decision-making, leadership, and impact on employee morale. If an individual personally guarantees the employer’s debts, a guarantor fee should be separately computed to keep any compensation issue out of the equation.

C Corporations

If a business owner is underpaid when cash flow is weak, he or she may be entitled to catch-up pay later. For an example, see Choate Construction Co., T.C. Memo 1997-495, in which the Tax Court upheld as reasonable pay of more than $1 million when business improved after the first two years of operations.

Directors should document the deferral arrangement in their minutes and consider including the liability on the balance sheet. If the company does not treat the deferred compensation as a real liability, the IRS may not either. The company must also be careful to comply with Sec. 409A, which provides strict rules regarding nonqualified deferred compensation plans.

CPAs should encourage business owner clients to develop a written compensation plan in advance and make note of all shareholders, directors, and officers who approved it. “[E]vidence of a reasonable, longstanding, consistently applied compensation plan is evidence that the compensation paid in the years in question was reasonable” [Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983)].

The compensation plan should include a method or formula for determining incentive amounts. Year-end bonuses are lightning rods for IRS examiners since they may be drawn from accumulated cash, which appears to be profits. A bonus should be tied to performance and not simply to the amount of cash in the bank at year end. Good notes are needed to explain how bonuses are earned and why they are worthwhile for the employer. These records may be the client’s best friend if the IRS raises a challenge.

Clients should include nonshareholders and nonfamily members in the bonus pool when appropriate. If year-end bonuses are paid only to shareholders and their relatives, the amounts may appear to be more like dividends than compensation. The bonus amounts should not be tied to ownership. For example, an officer who owns 20% of the company’s stock should not be assured of receiving 20% of the year-end bonus pool.

A bonus plan should be based on incentives related to the company’s goals. For example, if revenue growth is a major goal, bonuses may be tied to increasing sales. The senior management team may get a bonus pool of 15% of the amount by which revenue exceeds prior-year revenue. The CEO may get 30% of the pool, the president may receive 20%, and each vice president may earn 10%. Basing bonuses on a growth rate or net income is much safer than basing it on the cash balance. For practical business reasons, some restrictions should be included in the written bonus plan, allowing the board to cut the amounts to the extent that payment of the bonuses would reduce the current cash balance below the amount needed for working capital, expansion, and debt service. The board should also be able to delay payment of some or all of the bonuses it deems necessary to protect the company or to comply with loan covenants, government regulations, or contract requirements.

Another possible red flag for the IRS is a loan from a company to a shareholder. Auditors commonly examine such loans to see if they may actually be additional compensation or dividends that have been recorded as loans for tax avoidance. Such loans should be discouraged, especially if they will not be repaid within a year or are made without a good business reason. If a company does lend money to a shareholder, the parties should be encouraged to sign an enforceable note that bears a reasonable interest rate and is secured by appropriate collateral.

To keep bonuses from looking like dividends, closely held C corporations should consider paying small dividends every few years. When challenging a shareholder’s high pay, the IRS has a stronger argument if the company has never (or not recently) paid a dividend to its shareholders.

One of the hottest audit issues arises when a key employee, such as the founder of a company, nears retirement. Once he or she starts reducing work hours and transitioning major responsibilities to others, a reduction in pay should be carefully considered. Since a pay reduction is a sensitive subject, anyone who values his or her relationship with this key individual may be reluctant to bring it up. But CPAs should say whatever needs to be said.

Shareholders may see these steps as overkill, but complying with these tips can make a world of difference. Even if the IRS is successful in reclassifying a portion of a shareholder’s pay, the company should be prepared to show that it made “a reasonable attempt” to comply with the tax law so it can avoid a negligence penalty under Sec. 6662.

S Corporations

In family-owned businesses, it is common to give glamorous titles to family members who do not play key roles in the business. The thinking is that a shareholder who is not going to receive much compensation may be satisfied instead with a big title. At first glance, this seems like a harmless practice. However, the IRS may use those titles against the taxpayer when obtaining comparability data.

Published opinions from recent Tax Court cases have put a heavy emphasis on the use of comparability data to determine market rates of pay. When comparing one person’s pay to that of others in the same industry who have the same title, the IRS may conclude that a shareholder was underpaid. An adjustment to one shareholder’s pay may result in penalties for failure to withhold taxes and failure to deposit taxes. Furthermore, an adjustment to just one shareholder’s pay could cause distributions for that period to become disproportionate. Since S corporations are generally required to make distributions to shareholders on a pro rata basis (based on stock ownership), an increase in one person’s pay, with a corresponding decrease in that shareholder’s distributions, could create disproportionate distributions. In a severe case, disproportionate distributions could terminate the company’s S status.

When no compensation at all is paid to shareholders, encourage the filing of payroll tax returns anyway, even if the forms show zeroes. Then, if the IRS determines that some compensation should have been paid during those periods, the company should at least be able to avoid the stiff penalty for failure to file payroll returns.

Not-For-Profit Organizations

Loans from charities or foundations to their officers, directors, donors, and their family members should be discouraged because they could be viewed as disguised compensation. All payments to employees, independent contractors, donors, and family members are subject to close examination. In addition to compensation payments, these include rent payments, reimbursement of travel expenses, and loan repayments. These transactions should be properly approved in advance and well-documented.

Since few people have expertise in the areas of compensation and taxation, a board of directors may ask an independent compensation expert to review and evaluate a pay plan. Alternatively, the board can obtain comparability data to determine market rates of pay. The data should be current and drawn from comparable positions at similar organizations. If an opinion letter or comparability data are obtained and relied upon, the risk of a challenge is greatly reduced. The opinion and comparability data will also help avoid excise taxes under Sec. 4958 in the event of an adjustment by the IRS.

Conclusion

The subject of executive compensation is complex and controversial. It is especially sensitive and difficult to address after an IRS auditor has arrived and begun an inquiry. To avoid frustration, embarrassment, and tax penalties, CPAs should take the lead in helping to educate clients and to minimize the risks.

By Stephen D. Kirkland, CPA,CFF

Edited and posted by Harold Goedde CPA, CMA, Ph.D.

In accordance with Circular 230 Disclosure