Executive Compensation in a Closely Held Business: Make Sure It’s Not Too Low or Too High

By Mitchell Franklin, Ph.D., CPA, Madden School of Business at Le Moyne College – December 8, 2016
Executive Compensation in a Closely Held Business: Make Sure It’s Not Too Low or Too High

Corporate formation has significant liability issues as well as tax considerations. A key consideration is properly structuring executive compensation to stay out of trouble with the IRS.

The IRS aggressively examines C corporations to make sure that shareholder-employees are not overpaid and S corporations to make sure that shareholder-employees are not underpaid. The main concern facing owners of a C corporation is double taxation of dividend income, so it is common practice to pay an inflated salary to disguise the dividend as a tax-deductible payroll expense, reducing taxable income to the corporation and maximizing available fringe benefits. The S corporation attempts to minimize salary and increase non-salary distributions, which are not subject to payroll tax.

Reasonable compensation is governed under Reg. Sec. 1-162-7(a), which states that the salary or fringe benefits paid to a shareholder-employee must be reasonable in order to be deductible. As such, the IRS looks at the salary paid to an employee-shareholder and determines if it is reasonable based on the circumstances of the situation. If a shareholder-employee of a pizza shop structured as a C corporation takes $350,000 as an employee salary, is this reasonable? Conversely, if a CPA shareholder of an S corporation takes a $25,000 salary, is this reasonable?

Convincing the IRS that a compensation level for an owner-shareholder is reasonable can be difficult and controversial if there is not sufficient evidence to support a specific stance. Section 162 states that a deduction for salary can be taken for “all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business including a reasonable allowance for salaries and other compensation for personal services actually rendered.” To the taxpayer, compliance with Section 162 means that evidence must be provided to demonstrate that salary payments are made purely for services provided to the entity.

There are several cases that have been argued to determine reasonableness of compensation. Each case was decided based on a separate series of factors, and these factors historically involve the individual’s role in the company, comparison of similar companies, educational qualifications of the executive, consistency of pay to non-owner employees with similar duties, and the overall condition of the business.

C Corporation Considerations

To successfully defend a position before the IRS, a business must have a clearly documented compensation plan that is formally reviewed and approved by the board and shareholders and applied to all employees in a consistent manner. The plan should have a clear formula that supports salary decisions as well as calculation of any bonuses, which must be fully tied to individual performance. The plan should also clearly specify nonperformance criteria that would justify a higher base salary for similar services performed by a non-owner, such as advanced degrees, certifications or specialties that shareholder-owners may have which other employees performing similar work may not have.

S Corporation Considerations

To prevent the IRS from determining a salary is too low, having data to determine and support a specific salary as market-appropriate for a job title and duties performed is very important. IRS adjustments to pay back salary that was understated can be very expensive. The increase in salary will generate failure-to-withhold tax penalties as well as penalties for failure to properly deposit taxes. Shareholder-owners of family businesses should also be careful with the titles assigned, as market pay is tied to position. This is often an issue when relatives are given a leadership title with little responsibility, such as children or those who are retired from the entity.

Setting salaries of executives can be difficult and complex, and it is a hot area for IRS audits. CPAs need to actively engage their small-business clients in discussion to ensure that the salaries being paid are reasonable for the business entity and adequately supported by and consistent with current case law on the issue.

Mitchell A. Franklin

Mitchell Franklin, CPA, Ph.D., is program director and assistant professor of accounting at the Madden School of Business at LeMoyne College. He is a member of the NJCPA Content Advisory Board.

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This article appeared in the November/December 2016 issue of New Jersey CPA magazine. Read the full issue.