Compensating Owners of Closely-Held Businesses

by Travis Bogan and Landon Reese

Taxing authorities have heavily scrutinized the compensation of closely held business, applying a reasonableness standard. Reasonable compensation is defined in Treasury Regulations as “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” Before looking at whether compensation aligns with this definition, let’s first consider why this is an issue. For an S-Corporation, reasonable compensation can come into question when owners are paid a relatively small salary for services provided to the Company while paying relatively higher distributions. On the contrary, C-Corporations may encounter issues when the owner’s compensation exceeds what the IRS considers reasonable, with the IRS taking the position that it should be at least partially classified as a distribution of profits in the form of a dividend  .

When an owner of a C-corporation is providing services to the company as an employee, the company is generally incentivized to pay higher compensation. This higher compensation decreases its taxable income, thereby reducing its overall tax liability.  Therefore, paying out higher deductible compensation can be more appealing than paying nondeductible dividends, which results in double-taxation to the shareholder(s). This can lead to an “excessive” and “unreasonable” amount of compensation paid to the owners, which may raise a red flag to the IRS.

Conversely, an S-Corporation is incentivized to pay lower shareholder salary and higher distributions, which are not subject to double taxation. Additionally, unlike salary, distributions are not subject to payroll taxes. Therefore, coupling smaller compensation with larger distributions decreases the amount of payroll tax liability while netting the owner the same amount.

What qualifies as a ”reasonable” amount of compensation when paying owners, and how can one avoid trouble when setting compensation amounts? While there is not a bright-line test, there are some guidelines that both C-Corporations and S-Corporations can use to address this issue. The Tax Court case of Choate Construction Company v. Commissioner in 1997 was the genesis of the guidelines currently in place.

William Choate (Choate) incorporated Choate Construction Company in 1989. Choate worked extensively during the first 3 years of business before hiring and training other employees to help manage the company. In 1992, Choate received a salary of $935,000. Upon examination, the IRS took the position that the amount of compensation was excessive and, therefore, not deductible. Choate Construction Company challenged the IRS position in court with the burden of proving that William was paid a reasonable salary for his services to the Company. Ultimately, the Tax Court agreed with the Company, finding the amount of compensation paid to be reasonable – and in so doing, set a precedent for the qualifications of reasonable compensation.

The issue of Choate Construction Company v. Commissioner is an example of a C-corporation paying out compensation that appears unreasonably high. However, as explained above, an S-Corporation faces an entirely different issue regarding reasonableness. For example, Joseph Radtke found himself under scrutiny because he was paid no salary as the sole shareholder and director of an S-Corporation. Instead, he withdrew money from the S-Corporation through dividend distributions. Therefore, the reasonableness of his compensation - or lack thereof - was called into question. Ultimately, the court deemed that his dividends took the place of a salary and should be considered compensation subject to payroll taxes.

Although the issues raised are different between Radtke’s and Choate’s cases, the guidelines used by the Court in the Choate Construction Company case for setting reasonable compensation can be helpful across all businesses. A brief outline of the items to consider when setting compensation, many which relate to the decision in the Choate Construction case, are listed below:

1. Employee’s qualifications – This includes the employee’s education, intelligence, motivation, leadership, and the quality of services rendered.

2. Nature and scope of work – Contribution to the success of the business.

3. Size and complexity of the business – Consider how the amount compares to compensation paid for similar services by similar enterprises.

4. General economic conditions and financial condition of the company – General economic conditions can affect the company’s performance, thus showing the extent of the employee/owner’s effect on the company. The past and present financial condition of the specific company is relevant to the amount of compensation that can be paid.

5. Distributions to shareholders and retained earnings – If a corporation fails to pay dividends during profitable years, or if an S-Corporation pays out too much in distributions, it may be a sign that compensation was unreasonably set.

6. Whether the employee and employer dealt at arm’s length –  Some courts have applied an “Independent Investor Test” to determine if the salary is reasonable.

7. Salary scale for employees – The reasonableness of compensation paid to shareholders versus non-shareholders and unrelated employees is a significant factor.

8. Compensation paid in prior years – The IRS looks at an employee’s salary history to explain the compensation increases. The IRS may challenge deductions taken by the employer for such compensation if there is no corresponding increase to job responsibilities.

Applying these guidelines when setting compensation amounts provides justification if questioned by taxing authorities. Please contact a tax professional at Elliott Davis for further details as well as best practices for compliance.

‍The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.