Avoiding Unreasonable Compensation

Few issues are more frequently addressed by the tax court than the corporate deduction for wages paid to employee-shareholders, especially in closely held corporations. If the Internal Revenue Service (IRS) is successful in its contention that the compensation is not reasonable, the amounts paid in excess of a reasonable amount are recharacterized as nondeductible dividends.

There are no specific dollar amounts that courts can use as guidelines to determine the actual value of services. Therefore, determinations are made on a case-by-case basis, considering facts and circumstances unique to the situation and relying heavily on the intent of the parties involved.

What are the factors considered by the IRS and courts when determining whether compensation is reasonable?

The following are questions used by courts to determine whether compensation paid to shareholders is reasonable:

• Would an unrelated outside investor consider the compensation reasonable?
• How does the amount of compensation compare with the amount of dividends paid?
• How does the compensation compare with the profit performance of the corporation?
• Was the level of compensation arranged in advance, or was it based on corporate profit?
• What is the typical level of compensation in the corporation’s industry?

A compensation package would likely withstand scrutiny by the IRS if it approximates the amount that would be paid in an arm’s length transaction.

What about golden parachute payments?

The IRS defines a parachute payment as compensation that is contingent on the change of ownership or control of a corporation and paid to certain officers, shareholders, or highly compensated individuals. The part of the payment that exceeds three times the recipient’s base amount is not deductible as compensation by the corporation. In addition, the recipient is assessed a 20 percent tax on the excess amount.

Tip: The base amount is average annualized compensation payable for the five years prior to the change in ownership or control.

An arrangement involving a potential parachute payment should be carefully planned to avoid triggering IRS sanctions.

If you have questions or need assistance, contact the Experts at Henssler Financial:experts@henssler.com or 770-429-9166.

Disclosures

The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.