In a previous article, I discussed reasonable compensation and how it applied to owners of C-Corporations. With those type organizations, the issue is usually an owner compensation that is unreasonably high. In that situation, it could be construed that the compensation was actually a dividend, which would not be deductible at the corporate level.
But most businesses, particularly small businesses are 'pass-through' type entities. These include S-Corps, LLCs, and sole proprietorships. The problem is not a compensation that is unreasonably high, but one that is unreasonably low.
If you own one of these pass through type entities, you probably are aware that you pay taxes on the businesses earnings even if you take no money from the business. You might pay yourself a salary, on which you pay taxes, or you might take a distribution from equity. This distribution has already been taxed to you since earnings are passed to you personal income tax return via a K1.
So why would the federal, state, and local tax folks care if your compensation was too low? It has to do with payroll taxes, or more specifically FICA, Medicare, FUTA, SUTA, and in some cases local occupational type taxes. These type taxes are levied on compensation, but usually not on distributions Let's say your business earns a half million dollars. And let's say you are taking an annual salary of $10,000.00. You get a K1 for the $500,000.00, which goes on your income tax return. Your payroll taxes are applied to the ten grand, an not the $500 grand, and you congratulate yourself for making such a smart business decision.
Beware! Unless you can show that the relatively low salary of $10K is reasonable, you could be challenged in an audit, and receive a substantial bill for back taxes relating to the payroll taxes mentioned above. Note that these taxes have some very harsh punitive penalties associated with them. Suddenly the idea of keeping payroll taxes low by paying your self a salary that is below the market value is looking to be not such a goo move. To avoid this situation, the answer is simple: pay yourself a reasonable compensation.
That begs the question: "how does one determine what is reasonable?" to which the answer is not so simple. In many areas of tax law, there are specific rules for determining various amounts. There are safe harbors, there are online calculators, and there are schedules. With 'reasonableness', you are somewhat on your own.
While this gives the IRS some advantages in that they can challenge you from more than one angle, it actually works to the taxpayers advantage, since you can justify your claim of reasonableness using one or more criteria that people in business typically use. You can use simple things like hours worked, average salary for similar jobs in your industry, or you can use a return method such as commission or percent of profits.
It all begins by documenting your formula and criteria for paying yourself. If you do that, you are ahead of many small business owners in justifying your compensation to a tax auditor. You just want to make sure the formula and criteria used is, well,... reasonable.
Steve A. Porter, CPA, CMA
Steve Porter has over 30 years of accounting experience helping clients with taxes, accounting, computerized systems, and more. As a professional accountant with both Certified Public Accounting (CPA) and Certified Management Accounting (CMA) credentials, along with practical industry expertise, Steve can partner with you and an be a valuable business ally.
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