Avoiding IRS Challenges To High Shareholder Pay
by E. James Brennan
Reprinted From The February, 1994, Issue Of Contractors Compensation Quarterly
Excessive compensation is a problem you don’t mind… until the Internal Revenue Service knocks at the door.
Over the past decade, the IRS has been enthusiastically pursuing “unreasonable compensation” cases in small companies. I know, because I have been the IRS’s expert witness in over a hundred of these cases. In recent years, Taxpayers have increasingly sought my help after the Service raised the unwelcome issue of a tax deficiency because of “unreasonable compensation”. Having worked both sides, here’s my advice. The IRS can disallow corporate tax deductions for extraordinary salaries which the IRS claim were really “disguised dividends”. The typical IRS target is the highly paid stockholder-employee of a closely held corporation with no dividends. If handsome salaries and extravagant bonuses to owner-employees appear to evade the double tax on dividends, the firm may end up in tax court. Actions most likely to attract unwelcome IRS attention are: taking low salaries, then paying most of the profits out in monstrous year-end bonuses; it is the kiss of death to grant big bonuses in direct proportion to shareholdings.
There are eight major ways to justify high compensation to shareholder-employees:
1. Competitive analyses proving that other firms of similar size in the same industry paid similar compensation for similar work during the same periods.
2. Above average profits or other extraordinary corporate successes attributable to the shareholder-employee’s work.
3. Proof that the individual performs such unique and critical services that equal pay amounts would be necessary to attract an equally qualified replacement.
4. An overall company practice of equivalently generous compensation to all employees.
5. Documentation from past years demonstrating that the owner-employee deliberately worked for far less than normal pay in anticipation of being “made whole” for the historical under-compensation.
6. A logical and fair pre-existing plan of fixed or contingent compensation was followed, with actual pay not appearing to replace dividends.
7. The compensation rate, formula or plan was determined well in advance of the fiscal year end, before profits could be predicted.
8. Shareholder compensation was set by independent outside directors operating at an “arms length” distance, without undue shareholder influence.
Remember that with the IRS, you are assumed to be guilty until proven innocent; so prepare. You don’t want your pay to cost more than you ever intended.
E. James Brennan is a compensation expert used widely by both the IRS and tax defendants. As president of Brennan, Thomsen Associates, Inc., a Chesterfield MO pay practice firm, Mr. Brennan consulted nationwide and published an earlier version of this article as contributing editor of the Personnal Journal. Currently retired from consulting, he is Senior Associate at ERI Economic Research Institute ( www.erieri.com), 800 627 3697.