How to Ensure Your Officer Compensation is Reasonable

How to Ensure Your Officer Compensation is Reasonable

Throughout this year of economic upheaval, Congress and the US Treasury Department has put continual pressure on the IRS to produce additional tax revenue; the tax administration quickly responding with the intention to increase its enforcement of audits.

A common theme to many of those audits, reasonable officer compensation for S corporation shareholders has always been a hot spot for tax cases. With vagueness on the law providing enough confusion for business owners to either intentionally or unintentionally break it, the high penalties at stake are simultaneously just the “additional revenue” the IRS seeks.

So, if there’s no clear definition on what qualifies as “reasonable” officer compensation, how can shareholders know what to pay to act in accordance of tax law and to protect themselves from a possible future audit? Here’s a few tips to keep business owners on the straight and narrow…

Shareholders Count as Employees

While there’s no one-size-fits-all measurement of what constitutes as reasonable officer compensation, existing tax code does define S corporation shareholders as “employees” under the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and federal income tax withholding.

As such, all compensation received by the business owner – including fringe benefits like paid-for health insurance premiums – are considered wages and are thereby taxable under federal employment tax standards.

Test the Compensation with the 9-Point Rule

Operating on a case-by-case basis, whenever a tax court looks at an officer compensation lawsuit to see if the amount it reasonable, they consider these 9 factors:

  1. The responsibilities of the shareholder;
  2. The time and energy spent working for the business;
  3. The experience and training of the shareholder;
  4. What similar businesses pay for related industry services;
  5. The dividend history;
  6. What non-shareholder employees are paid;
  7. The contractual compensation agreements;
  8. The manner and timing that bonuses were paid to shareholders in the business; and
  9. Any other existing compensation formula.

Keeping these same factors in mind and testing them against the shareholder’s current officer compensation is a great way to help a business decide whether it’s reasonable or not – before the amount is questioned in an IRS audit.

Keep Detailed Records

Regardless of whether you’re a shareholder yourself or a tax professional representing one, the importance of maintaining detailed records explaining why the officer compensation received is reasonable, cannot be stressed enough.

From keeping up with changing economy standards and understanding whether a payment was too much or too little, to already having all the necessary information prepared in advance for a potential audit, it just makes everything simpler for a business to continually keep records on their procedures, policies, industry competitors, payments, services provided, shareholder working times, and their own unique reasonings behind the compensation offered.

Don’t yet have a tax professional working to provide you with accurate records? AB&P is always standing by to help to offer referrals to professionals and can be reached at (310) 534-5577 or contact@abandp.com.

We look forward to hearing from you!

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