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Facts
For many years, C-Corporations and S-Corporations have wrestled with "reasonable compensation" requirements for shareholder employees under code section 162 of the Internal Revenue Code. For a C-Corporation, the question arises when classification discrepancies exist between compensation in the form of wages for services rendered, and dividends. Dividends, as opposed to wages, are double taxed; once at the corporate level and then again at the shareholder level. Wages however, are a deduction to the corporation and shift the tax responsibility to the shareholder-employee. This results in an incentive to pay unreasonably high wages so the income is only taxed at the shareholder level and a deduction at the corporate level. In contrast, an incentive exists for Shareholder-employees of an S-corporation to pay little or no wages due to the fact that wages are subject to employment taxes in the form of Social Security and Medicare, and ordinary income passing through to the shareholder as a "distribution of profits" is not, but only taxed for income tax purposes.
Issues
Code section 162 allows for a deduction of "reasonable "compensation, but fails to define the term. Taxpayers are left to take a defendable position and define "reasonable" for themselves. The problem is that the IRS and the taxpayer many times do not agree. As a result, there have been many cases that have been litigated to come to terms with the ambiguity of the law and allow the courts to decide. Because of these court cases, reasonable has been better defined, although transparency is still an issue. Litigation has given guidelines for taxpayers to follow; however, each situation is so different, it is impossible to compare apples to oranges and make a solid decision. Many taxpayers, under advice of their CPA, use what is called the "60-40 rule." First, it should be understood that this is not an IRS rule. It was developed by practitioners as a simple guide for determining a reasonable salary. The IRS has not published any statement that this is a "safe harbor" for salary payments to the Shareholder-employee and there is no regulatory or judicial authority that substantiates it. Under a 60-40 approach, the split between salaries and distributions should be 60% for salaries and 40% for distributions of profits or dividends. For example, assume that the taxpayer is the only shareholder-employee in his/her S-corporation and is working full time. During the year he takes $100,000 in distributions from the corporation. His salary should be 60/40 X $100,000 = $150,000. Although this is only one interpretation of the rule, suppose no distributions are made from the corporation for the same year. Instead, he "plows back" the earnings into the corporation for future needs. Would this mean there is no reasonable salary requirement? If a reasonable salary is $150,000 when there are distributions, then a reasonable salary is $150,000 when there are no distributions. Also, why use a 60-40 split? Why not a 50-50 or 30-70 split? The 60-40 approach is an arbitrary rule, and many taxpayers are very optimistic of the aggressive position they take and many get these ideologies from their tax preparers. In fact, many tax preparers use a clean percentage across the board, regardless of the specific facts. Perhaps a more logical rule is to make the salary a percentage of the net business income of the corporation before considering the salary deduction, for example, between 30% and 40%. Suppose the taxpayer in the example above, before deducting his/her own salary, the net business income of the corporation is $250,000. A reasonable salary for him/her might be $100,000 under these circumstances, regardless of distributions. One could also base the salary on a percentage of gross revenue, since that indicates better than net income the extent of the shareholder's activity and responsibilities. The problem still exists that there is no "rule" or set of guidelines to specifically define what is reasonable compensation, and perhaps more importantly, what is not.
Authority
Code Section 3121(a) defines wages as "all remuneration for employment" for federal employment tax purposes. Section 3121(d) defines an employee on part as any officer of a corporation. There is an exception however under Reg. Section 31.3121(d)-1(b) for officers that perform no, or only minor services. 1.162-7(b) (3) states "In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances."
In Devine Brothers, Inc, TC Memo 2003-15, the corporate president's compensation was $260,378 for the tax year. The IRS disallowed $65,000 of the deduction as unreasonable compensation. The tax court favored on behalf of the taxpayer ruling that the employee was undercompensated in years past and the higher wages was justified as payment. This case demonstrates the processes and procedures the courts use to define reasonable. In this particular case, prior years' compensation was added to the formula. E.J. Harrison and Sons, 101 AFTR 2d 2008-1298 was a case that the IRS reclassified wages to dividends. In the case, The CEO was employed full time and was paid wages during 1995, 1996, and 1997 in the amount of $860,000, $818,000, and $600,000 respectively. She served on the board, represented the company at numerous charity events, and she personally guaranteed a line of credit. The IRS disallowed the deduction for most of the wages arguing that the CEO's services were equivalent to those provided by an outsider serving as chair of the board of directors and only allowed a deduction for wages of $54,000 to $59,000 for each year. (E.J. Harrison and Sons, TC Memo 2003-239). The Ninth Circuit Court of Appeals disagreed regarding the comparison to an outsider and remanded the case for a redetermination of reasonable compensation. The tax court then found the compensation reasonable of all actual compensation and remuneration paid for the years (E.J. Harrison and Sons, TC Memo 2006-133). This tax court decision was affirmed by the 9th Circuit (E.J. Harrison and Sons, 101 AFTR 2d 2008-1298) This case demonstrates the use of determination of actual services rendered, comparative salaries by comparable services from comparable corporations. It also demonstrates the complexity of the decisions and illustrates the fact that the determination of reasonable compensation is very subjective and lends itself to continuous litigation. Conclusion/Recommendation
Several tax court decisions have focused on a variety of factors because of the nontransparent nature of the issue and the many variables that must be considered to define "reasonable" in this instance. Some of these considerations include:
The character and financial condition of the corporationThe role the shareholder-employee plays in the corporation, including position, hours worked and dutiesThe corporation's compensation policy for all employees and the history of paid salaries to shareholders, including consistency thereofComparisons with similarly situated employees of other companies of past casesWhether the hypothetical, independent investor would conclude that there is an adequate return on investment after considering the compensation of the shareholderThe corporation's dividend history • Salaries versus distributions and retained earningsGeneral economic conditionsComparison of salaries paid to sales and net incomeSize and complexity of the business
Conclusion
When establishing reasonable compensation, no single factor controls the decision process; rather, a combination of the factors must be considered. Furthermore, these factors are not all-inclusive and may not be given equal weight. Every situation is different and may be without precedent. When justifying wages, the taxpayer should take all facts into consideration. Although there is little guidance regarding the definition of reasonable compensation and coupled with a clear incentive to lean to the high or low side of reasonable, the courts seem to favor taxpayers that can justify the means by providing the necessary documentation substantiating their decisions. In addition, the court cases that have ruled against the taxpayer have generally been situations in which the taxpayer is clearly unreasonable and not toeing the line. Some forms of justification, however, more forms may be required, are turning to the internet to websites that publish fair-market-value wages based on position and location such as http://www.salary.com, comparing to industry standards and benchmarks, researching tax court cases and revenue rulings. No matter how the justification is made, it must be understood that the position taken can and may be challenged with the position ultimately being overturned. Reasonable has a different meaning to everyone, and in general, the definition adopted will reflect the self interest of the adopting party. In conclusion, one must consider all aspects and facts regarding reasonable wages paid to a shareholder-employee in order to determine a justifiable and defensible position. There are reasonable methods to determining what is reasonable, however, all positions should be adequately documented and carefully considered.
