Reasonable Compensation

01 Jul 2021

What Is Reasonable Compensation For Employees of An I.R.C. § 501(c)(3)? (Part 1)

One of the most important decisions a board determines is what constitutes reasonable compensation. The rules for this determination are robust and so are the taxes imposed for violations of the Internal Revenue Code and the corresponding Treasury Regulations. In this 2-Part series, we examine the taxes imposed for unreasonable compensation and explain the steps for determining reasonable compensation. In this Part 1, we introduce the persons potentially subject to the taxes and the taxes themselves.

Whose compensation is possibly subject to I.R.C. § 4958 taxes?

Written by John Reyna | Posted in Reasonable Compensation

16 Sep 2020

Clarifying The Contours of “Reasonable Compensation”

The law has always favored the term “reasonable.” For example, the law affords protection against a negligence lawsuit if a person can demonstrate he or she acted as a reasonable person would have under similar circumstances. Moreover, federal tax law provides that a taxpayer may generally avoid federal tax penalties if the taxpayer had “reasonable cause” for a failure to comply with the Internal Revenue Code (the “Code”).

But, what is “reasonable”? For those who prefer bright-line rules, you will not like the answer. What is reasonable is often in the eye of the beholder, i.e., the decision maker. Stated differently, what is reasonable is difficult to ascertain in many cases because what is reasonable to one person may not necessarily be reasonable to another.

Given these ambiguities, it is no surprise that taxpayers and the IRS have historically quibbled over a corporation’s “reasonable allowance” for salary and other compensation. Because of the nature of subchapter C of the Code (applicable to C corporations), there is almost always a natural incentive to reduce the dual level of taxes at the corporate and individual level through paying higher compensation.[1] However, in many instances, corporations also legitimately want to pay their employees, particularly hard-to-replace executives, competitive salaries and bonuses for hard work. This Insight discusses the reasonableness requirement for deduction of compensation under Section 162(a)(1) of the Code.

Written by Matthew Roberts | Posted in Reasonable Compensation

14 Apr 2020

Internal Revenue Service Lays Out Steps To Keep Reasonable Compensation Out Of Court

IRS Lays Out Steps To Keep Reasonable Compensation Out Of Court

In a memorandum to its examiners and appeals agents, the IRS lays out steps to keep Reasonable Compensation challenges out of Tax Court. Great, you say, nobody wants to go to court!

Not so fast. The option of filing a petition in Tax Court provides taxpayers with time and leverage. By following the steps in this memo, IRS examiners can prevent taxpayers who cannot reach a resolution on Reasonable Compensation from filing a petition in Tax Court. This means:

Tax must be paid now. When filing a petition with the Tax Court, taxpayer can avoid paying the tax until the matter is finally resolved.
Leverage Lost. Filing or even the threat of filing a petition with the Tax Court can give taxpayers and their advocates’ leverage to get the appeals agent to settle the dispute favorably.

Since 2005, when the IRS began studying the issue of compliance and Reasonable Compensation, the agency has been regularly and consistently improving enforcement and compliance strategies. This relatively unknown memo, prepared by Janine Cook, Deputy Associate Chief Counsel (Exempt Organizations/Employment Tax/Government Entities) to Barbara Wulf, Program Manager (Specialty Exam Policy & Quality, ET policy), is another example of their continued efforts to do just that.
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Written by Kat Jennings | Posted in Reasonable Compensation • S Corporation Compensation

21 Feb 2020

What If An S Corp Owner Can’t Afford To Pay Reasonable Compensation?

This is by far the number one question we receive, and the answer is both simple and complex. Why? Because the amount of Reasonable Compensation actually paid is tied to distributions, not profit or loss.

Depending on the company’s financial condition and business strategy, a shareholder-employee may be able to take Reasonable Compensation plus a distribution, just Reasonable Compensation, or neither. What the shareholder-employee can’t do take a distribution instead of Reasonable Compensation.

To help you better understand, let’s run through a few simple scenarios and then move onto some more advanced ones. Keep in mind the following:

Reasonable Compensation is defined by the IRS as: “The value that would ordinarily be paid for like services by like enterprises under like circumstances.” or the hypothetical “Replacement Cost” of the shareholder-employee.

Reasonable Compensation is based on the value of services provided (Hypothetical Replacement Cost), not profit, distributions or the amount the company can afford to pay.
Wages (Reasonable Compensation) should be paid BEFORE distributions are made.
A shareholder-employee can take wages (Reasonable Compensation) without taking a distribution, but not vice versa.
A shareholder-employee who does not want to take any Reasonable Compensation can refuse all compensation (distribution), and play ‘catch up’ in a later year.
Reasonable Compensation is derived from the value of the services provided, not the profit or loss of the business. While Reasonable Compensation has nothing to do with profit and loss, it does relate to Distributions. Why? Because the IRS guidelines for Reasonable Compensation state: The amount of reasonable compensation will never exceed the amounts received by the shareholder either directly or indirectly. It does not mention profit or loss at all but instead talks about ‘amounts received’ by the shareholder. It does not matter if the company is making or losing money; what matters is whether or not the S Corp owner is taking money (e.g. a distribution or other items of value) out of the S Corp.
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Written by Kat Jennings | Posted in Reasonable Compensation • S-Corp

19 Jul 2018

S Corporation: What Is Reasonable Compensation For Employees?

When computing compensation for employees and shareholders, S corporations may run into a variety of issues. The information below from the IRS may help to clarify some of these concerns.

S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense which are subject to employment taxes.

Written by IRS | Posted in S-Corp