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Bar News - December 16, 2015

Business Law & Business Litigation: Reasonable Compensation Considerations for Corporations


Imagine your client is the owner of a new startup company who puts in long hours of hard work. The effort is beginning to pay off, and revenue is flowing into her company. How can your client legitimately move those company funds into her pockets?

For shareholders of corporations, the choice is generally between receiving dividends and being paid a salary and bonus. However, you’ve heard all about the cost – in terms of dollars, stress, and time – of IRS audits. What should you advise your client to do to enjoy the fruits of both her labor and her ingenuity while not running afoul of the law?

The last thing a business owner wants to deal with is a dispute with the IRS. Among many important aspects of a business to consider, entrepreneurs just starting out and small business owners in general should be aware of differing tax treatment of C corporations and S corporations at the federal level in compensating shareholders of a corporation who are also employees.

Although limited liability companies are increasingly popular, corporations are still regularly used, especially by companies that someday hope to “go public.”

Corporations generally come in two flavors for federal income tax purposes – “C” corporations and “S” corporations, although both types are the same for state corporate law purposes. The income of “C” corporations is subject to two levels of tax at the federal level – the often bemoaned “corporate double tax.” (Note that New Hampshire’s quirky tax system adds additional levels of complexity that are beyond the scope of this article.)

A C corporation can, however, deduct “reasonable” compensation in computing it’s taxable income pursuant to §162(a)(1) of the Internal Revenue Code. Dividends, though, are not deductible. By paying all net income of a corporation out as wages to its owners (or to relatives who are also employees), and not distributing dividends, double taxation can be minimized. However, this method of compensation may be questioned by the IRS because, in order to be deductible, compensation paid must be “reasonable” for the services rendered.

The income of an S corporation, in contrast, is generally subject to a single level of tax because income earned “passes through” to its shareholders. Only certain “small business” (a term that can be misleading, as revenues, number of employees and operations can be large) corporations are eligible to elect to be treated as S corporations, and several criteria need to be satisfied, primarily having to do with the limited number and identity of shareholders.

It can be advantageous for an S corporation to make payments to shareholders as dividends rather than compensation, because compensation payments are subject to payroll tax and dividend distributions are not. The IRS may question this method of compensation if it deems such compensation payment “unreasonably” low.

This differing treatment of C corporations and S corporations at the federal level creates an ironic “whipsaw” situation regarding the IRS’s position on the compensation paid to shareholders who are also employees. In short, it is in the interest of C corporations to claim large deductions for compensation paid to their shareholder employees, and it’s in the IRS’s interest to limit the amount of compensation which it deems is “reasonable” in these cases.

In contrast, S corporations may try to limit compensation paid to shareholder employees (due to payroll tax planning purposes) and distribute nearly all cash out via dividends. In these cases, the IRS is in the opposite position – claiming that S corporations have not paid sufficient “reasonable” compensation for services rendered by shareholder employees (as the IRS will receive the same income tax on the corporation’s income that flows through to S corporation shareholders, but will not receive payroll tax on the dividend payments, as those employment taxes are only paid on wages).

The United States Court of Appeals for the First Circuit has looked to the following factors in determining whether compensation paid was “reasonable”: (1) What an arm’s-length owner would pay the same employee for work performed; (2) General performance of the company, including return on equity; (3) Comparability of compensation with pay for similar jobs at like companies and with others within the same company, especially non-owner employees; (4) Employee role(s) in the company; and (5) Whether compensation was legitimately rewarding past underpayment. Haffner’s Service Stations, Inc. v. C.I.R. (1st Cir. 2003). These are highly facts- and circumstances-based determinations, and no single fact pattern will apply in all cases. Therefore, it is important for both C and S corporations to be able to support compensation paid as “reasonable” considering the factors listed above.

In light of the potential risks of IRS recharacterization of compensation paid as either “unreasonably” high, or “unreasonably” low, individuals starting or operating a small business should take care to minimize the risk of an IRS recharacterization before it arises. Documentation of compensation decisions in board minutes or in employment agreements, after benchmarking, is a good first step for a start-up or small business. Any benefits provided by the business or year-end bonuses should also be documented to properly support compensation decisions. If not all shareholder employees are providing the same services (i.e., if they have different roles in the company), they should not all be paid the same salary. Doing so looks to the IRS like a “disguised” dividend.

In addition, it may be prudent for a C corporation to pay some dividends, such that not all income is “comped out.” Similarly, shareholders of S corporations who provide services to the company should be paid some compensation in the form of wages, in addition to receiving dividends.

As is often the case, a little forethought and advance planning can go a long way towards avoiding the stress and considerable expense of a dispute with the IRS.

Tony Sayess

Alexandria Russell

Tony Sayess is chair of the New Hampshire Bar Association’s Tax Section and vice chair of the Corporation, Banking and Business Law Section. Alexandria Russell is clerk of the Corporation, Banking and Business Law Section. Both are business attorneys at Rath, Young and Pignatelli, focusing on transactional and tax matters.

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