What is 'reasonable' compensation?As a small business owner, you need to ensure that your compensation reflects what others would receive for performing similar duties in a similar setting. Not only is this important for tax purposes, but it’s needed to determine the value of your business.

Total Compensation Package

As the business owner, you’re likely to have related perks, as well as bear certain hidden costs. To determine what is a reasonable compensation, all components need to be considered, including:

  • Direct salaries, bonuses and commissions
  • Stock options and contingent payments
  • Payouts under golden parachute clauses
  • Shareholder loans with low (or no) interest and other favorable terms
  • Company-owned or leased vehicles and vehicle allowances
  • Moving and relocation expenses
  • Rent expenses
  • Subsidized housing and educational reimbursements
  • Excessive life insurance or disability payments
  • Other perks, such as vacations and discounted services or products
  • Management and consulting fees
  • Noncompete covenants

IRS Guidance

IRS field agents regularly conduct audits to estimate owners’ total compensation package and if that compensation is reasonable. According to the IRS, “Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”

They particularly lookout for C corporations that pay employee-shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t. If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

In contrast, the IRS looks at S corporations, partnerships and other pass-through entities that underpay owners’ salaries to minimize state and federal payroll taxes. S corps are more likely to pay distributions to owners, because distributions are generally tax-free to the extent that the owner has a positive tax basis in the company.

The IRS uses several data sources support compensation levels, including:

  • General industry surveys by Standard Industry Code (SIC) or North American Industry Classification Systems (NAICS),
  • Salary surveys published by trade groups or industry analysts,
  • Proxy statements and annual reports of public companies, and
  • Private company compensation reports such as data published by Towers Watson, Dun & Bradstreet, the Risk Management Association or the Economic Research Institute.

Compensation Benchmarks

Taxes aren’t the only issue where reasonable compensation can come into play. Shareholder disputes, marital dissolutions and other litigation matters could present issues where compensation could be considered. When valuing a business for these purposes, a company’s income statement may need to be adjusted for owners’ compensation that’s above or below market rates. A lack of comparable companies could make determining that market value difficult, but to do so, courts generally consider five key areas:

  1. The individual’s role in the company
  2. External comparisons of the salary with amounts paid to similar individuals in similar roles
  3. Character and condition of the company
  4. Potential conflicts of interest between the individual and the company
  5. Internal inconsistency in the way employees are treated within the organization.

These external comparisons are important, because a business owner can control their compensations, so there’s an inherent conflict of interest when estimating what’s reasonable.

Get It Right

Filler & Associates offers business valuation services, which could be useful in determining reasonable owner compensation. Contact us to learn more.