The process for determining a reasonable compensation amount for IRS purposes is not easy. It is the age old issue in tax of fairness vs. simplicity. A simple system could result in better compliance however, it might be an unfair tax burden on some. On the flipside, a complicated system might be fair tax wise but could result in poor compliance because of a lack of understanding and financial resources.
The IRS provides general guidelines which are a starting point. Court cases on the subject have resulted in more information around which variables are important and how we should weigh them. Despite this however, there are still several factors which make the process difficult for practioners such as…
- Many different approaches that can conflict such as Investor Model, Ratio Analysis, etc.
- Findings from C-Corps court cases that have been miss applied to S-Corps cases.
- Cases that have focused in on less important variables such as compensation of the highest paid non-shareholder employee causing confusion.
The employee of an S-Corporation who is also a shareholder provides a unique problem for tax purposes. The shareholder-employee wears two hats which are obviously that of an employee requiring a salary for work and that of an investor, requiring a return on investment. Both forms of compensation have different sets of tax issues. The largest area of uncertainty is around the general concept of company performance and how that effects salary. If a company does well, is that the result of the employee role and therefore payable as bonus compensation or is it the normal return on an investment and therefore payable as distributions to the investor? The correct answer is usually somewhere in between.
We use a “funnel” type of approach to zero in on what we believe is a fair amount for reasonable compensation. We start by setting the outer limits which are plainly rooted in case law. We then go step by step moving from certainty in tax law to discretionary areas until we come up with our conclusion on the amount.
We rely on the latest data and when guidance is missing, we will make a conservative reasonable assumption based on accounting and tax rules that are common in related areas. Our goal is to provide a strong set of defendable workpapers in an efficient manner.