{"id":4064,"date":"2018-08-06T12:25:53","date_gmt":"2018-08-06T19:25:53","guid":{"rendered":"http:\/\/celebrated-metal.flywheelsites.com\/?p=4064"},"modified":"2022-02-17T16:02:49","modified_gmt":"2022-02-17T23:02:49","slug":"how-much-owners-compensation-is-reasonable","status":"publish","type":"post","link":"https:\/\/analyticbusinessappraisers.com\/how-much-owners-compensation-is-reasonable\/","title":{"rendered":"How Much Owners\u2019 Compensation Is \u201cReasonable\u201d"},"content":{"rendered":"

Abstract: \u00a0<\/b>\u00a0The IRS may challenge the reasonableness of compensation a business pays to its owners and other related parties under a variety of situations. This article explains the factors to consider when evaluating compensation paid by C corporations and pass-through entities, including S corporations, partnerships and limited liability companies (LLCs) treated as partnerships for tax purposes. A sidebar highlights IRS internal guidance that provides valuable insight on how IRS examiners are trained to assess what\u2019s reasonable.<\/span><\/p>\n

How much owners\u2019 compensation is \u201creasonable\u201d?<\/b><\/p>\n

The IRS may challenge the amount of compensation a business pays to its owners and other related parties under a variety of situations. Knowing the factors the U.S. Tax Court will weigh when evaluating compensation for reasonableness can help your clients come out on top.<\/span><\/p>\n

Framing the issue<\/b><\/p>\n

Internal Revenue Code Section 162 allows the deduction of ordinary and necessary business expenses, including reasonable compensation. Sec. 162 defines reasonable compensation as the amount that would ordinarily be paid for like services by like organizations in like circumstances. <\/span><\/p>\n

Sometimes, the IRS claims that a C corporation has overpaid an individual and reclassifies excessive payments as disguised:<\/span><\/p>\n

Dividends<\/i><\/b>.<\/b> Dividends are taxed twice. Unlike compensation payments, dividends aren\u2019t deductible for federal income tax purposes. So, the corporation pays income tax on the earnings. Then, the recipient pays personal-level tax on the dividend income.<\/span><\/p>\n

Gifts<\/i><\/b>.<\/b> The IRS may say that an overpaid relative received a disguised gift, which may be subject to gift tax if it\u2019s above the annual exemption (which is $15,000 for 2018) \u2014 unless the donor taps into his or her lifetime estate and gift tax exemption ($11.18 million for 2018). <\/span><\/p>\n

When assessing reasonable compensation, the IRS looks at the <\/span>full<\/span><\/i> compensation package, including W-2 wages and other perks. Loans the business makes to owners and other related parties at no or low interest could represent another form of compensation.<\/span><\/p>\n

When it might be understated<\/b><\/p>\n

Sometimes, S corporations may try to <\/span>underpay<\/span><\/i> shareholder-employees to avoid federal and state payroll taxes. Then the company makes up for the below-market salary by making cash distributions to the owner(s) that aren\u2019t subject to payroll taxes. <\/span><\/p>\n

The Tax Cuts and Jobs Act could provide an extra incentive to underpay owners of pass-through entities: the deduction for <\/span>up to 20% of qualified business income (QBI<\/span><\/i>). Reasonable compensation paid to owners of a qualified business (including guaranteed payments to partners and LLC members treated as partners for tax purposes) must be deducted when computing QBI. So, the lower the compensation deductions, the higher the QBI deduction for qualified businesses. <\/span><\/p>\n

However, the QBI deduction is also limited to 50% of the W-2 wages paid by a qualified business. This limitation doesn\u2019t kick in until a taxable income threshold is reached at the owner level: $157,500, or $315,000 for a married joint-filer. Reasonable salaries paid to S corporation shareholder-employees count as W-2 wages for purposes of computing this limitation. (Guaranteed payments to partners and LLC members treated as partners don\u2019t count as W-2 wages.) <\/span><\/p>\n

For example, suppose a single-owner S corporation has QBI of $1 million after deducting $250,000 of owners\u2019 compensation and $300,000 of W-2 wages paid to nonowner employees. Its QBI deduction would be $200,000. This equals the lesser of 1) $200,000 (20% of $1 million), or 2) $275,000 (50% of $550,000 of W-2 wages). <\/span><\/p>\n

Conversely, if the owner of this hypothetical S corporation increased her salary to $500,000, her QBI would be $750,000. So, the QBI deduction would be only $150,000. This equals the lesser of 1) $150,000 (20% of $750,000), or 2) $400,000 (50% of $800,000). <\/span><\/p>\n

To complicate matters even further, QBI deductions are limited for certain types of service businesses, such as medical practices and law firms, when an owner\u2019s taxable income exceeds the applicable threshold. <\/span><\/p>\n

Analyzing compensation<\/b><\/p>\n

The U.S. Tax Court has historically favored a market approach that compares an owner\u2019s compensation to what employees are paid for performing similar duties at similar companies. Other issues the court considers when estimating reasonable compensation include the following:<\/span><\/p>\n