You Are Your Best Defense
Reprinted From The May, 1995, Issue Of Contractors Compensation Quarterly
Why fill out those construction compensation surveys? Because you are your own best defense!
PAS continually receives inquiries from CPAs, attorneys and exasperated owner/employees looking for information to help defend against IRS claims of unreasonable pay. We alert our CCQ subscribers to the fact that the Internal Revenue Service is conducting a systematic investigation of contractor pay, particularly executive pay. The purpose of these investigations is to identify and stop what the IRS refers to as “unreasonable compensation.” These allegations of unreasonable compensation give contractors, regardless of size or type, one more good reason to participate in industry compensation surveys.
The fact is, ninety-eight percent of construction firms are closely held corporations. Most are owned by fewer than four owners and frequently these owners are family members. The strength of these firms is the strong work ethic, independence, and “can do” attitude of their owners. This strength, however, can also be a weakness. Failing to see the need for mutual support, construction owners can wind up shooting themselves in the foot. Whether it be for the purposes of supporting favorable industry legislation or establishing appropriate compensation parameters, pooling of information and resources is very important to an individual firm’s ultimate success. IRS claims of unreasonable compensation are a case in point.
Unreasonable compensation is direct pay, usually, but not always, in the form of a large bonuses to shareholder/owners. The IRS looks at such large bonus distributions not as legitimate bonus, but rather as avoided dividend payments. Dividends, of course, are subject to corporate and personal tax whereas bonus distributions are deducted as a corporate expense and taxed as the recipient’s personal income. What the IRS is claiming is that these large bonuses, quite common to the industry, are “abnormal” and therefore unreasonable. Unless the target owners can prove otherwise, they and their corporations pay back taxes and penalties that can run into the tens of thousands of dollars.
The predicament in which construction owners find themselves is that they must prove they haven’t done anything wrong. As James Brennan (an expert witness used by contractors and the IRS) pointed out in our February, 1994, issue of CCQ, “You are assumed guilty by the IRS until you prove yourself innocent.” In other words, you must prove that your pay is reasonable. Now, how do you do that?
Here is one example. Owners of construction firms have a practice of “making themselves whole” in good economic times. They take little during the lean years and “reimburse” themselves for their sacrifices when the firm becomes profitable. To someone unfamiliar with the industry’s ups and downs such reimbursement can look “unreasonable”. Consequently, without a way of showing the normality of such practices, owners leave themselves open to unreasonable compensation charges.
The most objective way to prove that compensation is within the “normal” parameters of the industry is to use industry surveys. These surveys, like our Executive Compensation Survey For Contractors, help define what the industry standard is. This is precisely why participation is so important. You are your best defense. By participating in industry surveys, your compensation information helps define what the norms for the industry are, thereby establishing the very evidence you need in order to adequately defend your pay practices.
While industry compensation surveys certainly are not the only proof needed in these kinds of cases, they definitely help. So when the next survey form arrives, don’t just toss it. By participating, you are helping yourself and your industry.