There are two universal principles regarding the reasonableness of employee compensation: (i) most people feel they are under-compensated and (ii) those same people feel their friends and neighbors are overcompensated. There are many reasons for this phenomenon, but for our unscientific purposes it’s enough to think of reasonableness like beauty – it’s in the eyes of the beholder.
The tax world is no different, except the incentives differ when it comes to determining how much compensation is “reasonable.” The particular tax incentive will depend on the type of entity and tax involved.
For starters, the concept of reasonable compensation does not apply to businesses operating as a partnership or sole proprietorship because partners and sole proprietors are not considered employees and they do not receive a W-2 wage statement. Instead, the earnings of partnerships and sole proprietorships are subject to federal income and self-employment taxes regardless of how they are received.
The concept of reasonable compensation comes into play with C corporations and S corporations, and then almost exclusively in the context of compensation paid to owners of the business. In some circumstances, taxpayers are better off tax-wise if they pay shareholder-employees a higher salary; in others, they are better off paying a lower salary. This creates an interesting tension between taxpayers and the IRS because they end up on both sides of the reasonable compensation issue, which is uncommon in the tax arena. Usually, the IRS is expected to argue one position and taxpayers the opposite. For example, taxpayers frequently deduct items that the IRS disallows, but the IRS generally does not argue that taxpayers should have deducted an expense they did not deduct. With reasonable compensation, taxpayers need to thread the needle between paying an amount that is too high or too low depending on the situation.
Let’s see why that is the case.
C corporations can deduct no more than a “reasonable allowance for salaries and other compensation for personal services.” (There are additional limitations on publicly traded corporations not discussed here.) This is considered an ordinary and necessary business expense, and the amount that is considered “reasonable” serves as an upper limit to the amount that can be deducted – anything over such amount is termed lavish or extravagant. Thus, if the IRS were to challenge a taxpayer’s deduction for compensation (which includes regular pay and a bonus) as unreasonable, then it would argue the amount paid exceeds an ordinary and necessary amount. Note the IRS would not challenge the taxpayer’s ability to pay its employees whatever it wants; rather, the IRS would argue that the “unreasonable” portion of the compensation is not tax-deductible.
With S corporations, the reasonableness of salary usually serves as a floor – a minimum amount that is necessary to prevent a recast of earnings distributions into wages. If the IRS were to challenge an S corporation’s deduction for compensation as unreasonable, then it would argue the amount paid was insufficient, and that the taxpayer’s earnings distribution was really a disguised payment of wages, and therefore subject to employment taxes. Let’s see why that is the case.
An S corporation offers pass-through taxation, i.e., one layer of taxation at the shareholder level. This is more favorable than the taxation of a C corporation, which involves two levels of taxation – once at the entity level and a second time at the shareholder level when profits are distributed. The tradeoff for the favorable tax treatment afforded to an S corporation is that it is subject to restrictive qualification requirements, such as: (i) it must be a domestic corporation, (ii) its shareholders must be individuals or certain trusts or estates – no partnerships, corporations, or nonresident aliens, (iii) it cannot have more than 100 shareholders, (iv) it can have only one class of stock, and (v) it cannot be an ineligible corporation like a financial institution or insurance company.
Employment Taxes
Many businesses that elect S corporation status do so because of the ability to minimize employment taxes on the earnings distributed to the owner(s) of the business. Employment taxes apply to the wages paid to employees, including shareholders that work in the business, but not to distributions of earnings to the shareholders.
Consider a profitable business that earns $3 million a year for its sole or principal shareholder. If the $3M is paid to the shareholder in the form of salary or bonus, then the employment taxes applicable to the S corporation and to the employee would total about $130,428, consisting of a Social Security tax of 12.4% on wages up to $147,000, Medicare tax of 2.9% on all wages, and the additional Medicare tax of 0.9% on wages over $200,000 (we ignore federal unemployment taxes (FUTA) on the employer because the amount is negligible).
If, however, the S corporation were to limit the compensation expense to $1M instead of $3M and call the other $2M a distribution of earnings, then the employment taxes applicable to the S corporation and to the employee would total about $54,428, netting the S corporation/shareholder economic unit about $76,000 in tax savings at the federal level. There would be state employment tax savings as well.
If you’re still paying attention, then you’re probably asking yourself why not just reduce the compensation to zero and call the whole $3M a distribution from the S corporation, and avoid employment taxes altogether? While that works from a mathematical perspective, it does not work from a tax perspective. How do we know that? Because the IRS said so back in 1974 when it issued Revenue Ruling 74-44 to recharacterize dividends paid in lieu of wages as wages. Moreover, courts have routinely held that when an officer or shareholder provides more than minor services to a corporation and receives or is entitled to receive a payment, then such person is an employee of the corporation and is subject to federal employment taxes. Treasury and the IRS even memorialized this rule in regulations, and the regulations apply even if the parties designate the payment as something other than wages. Labels are immaterial in this context.
So what is a reasonable allowance for compensation? To start with, the IRS provides no clear guidance on points – no ranges, no safe harbors, no rules of thumb, though it did publish a Fact Sheet in 2008 and a Job Aid in 2014 for IRS valuation professionals. Even though some would be tempted to fault the IRS for not issuing clear guidance, more likely its silence reflects a recognition of the fact that reasonableness is very fact sensitive and what is reasonable in one context may be unreasonable in another. Thankfully, courts have filled in the gap by developing a list of factors to consider: (i) training and experience, (ii) duties and responsibilities, (iii) time and effort devoted to the business, (iv) dividend history, (v) payments to non-shareholder employees, (vi) timing and manner of paying bonuses to key people, (vii) what comparable businesses pay for similar services, (viii) compensation agreements, and (ix) the use of a formula to determine compensation.
Recognizing that the determination of reasonableness is more art than science, some practitioners suggest a 60-40 approach as a rule of thumb – that at least 60% of the amounts distributed to the shareholder should be categorized as wages, and the remainder can be distributed as profits. This seems conservative, especially since then-Senator Joe Biden and his wife, according to press reports, including in 2017 and 2018 about 2% and 13%, respectively, of their S corporation’s income as wages. In 2019, however, they increased that percentage to about 60% of their S corporation’s income as wages.
Other practitioners refer to comparable salary data on government websites (like the tax statistics published by the IRS), in trade publications, and on job-related websites like Monster.com or Salary.com, to determine the average salary for owners of businesses in their industry. This is helpful, but it doesn’t account for many relevant factors like regional differences or differences specific to the business and to the individual performing the services.
There is usually a range of acceptable wages in any particular situation, and if you find yourself in court with a reasonable compensation dispute, your lawyer most likely will hire an expert witness to perform a compensation study and the IRS will engage its own expert for the same purpose, and there will be a battle of the experts.
Income Taxes
The top tax rate applicable to C corporations is 21% after the passage of the Tax Cuts and Jobs Act (TCJA) in 2017. C corporations receive no deduction for dividends, and shareholders are required to pay an additional tax of 20% on their receipt of qualified dividends plus the net investment income (NII) tax of 3.8% if their income exceeds certain thresholds. To minimize this tax burden, owners of C corporations often attempt to eliminate the tax burden by zeroing out the corporation’s taxable income with bonus payments. Even though the owner pays income and employment taxes on the wage income, the corporation pays zero (or reduced) income tax and the overall tax burden is lowered.
This strategy, while effective, does not always work. The IRS has the ability to thwart it by recasting the unreasonable portion of the wages as a nondeductible dividend. The Tax Court recently considered such a scenario where a business owner tried to reduce corporate taxes by dramatically increasing his salary when the business took off. In Clary Hood, Inc. v. Commissioner, T.C. Memo. 2022-15 (March 2, 2022), the Tax Court rejected the corporation’s attempt to reduce its tax burden in this manner and held that a large portion of the compensation paid to the owner was unreasonable, and thus nondeductible.
The taxpayer in Clary Hood was a C corporation owned by a husband (Mr. Hood) and wife. Mr. Hood was the CEO and ran the business. In 2014, the corporation paid and deducted Mr. Hood’s combined salary and the bonus of $1.7M, and in the following two years – the years in issue, 2015 and 2016, it deducted a wage expense of $5.2M each year. Gross income from 2014 through 2016 was $10M, $13.9M, and $22.1M, respectively, and gross revenue was $34.1M, $44.1M, and $68.8M, respectively.
The Tax Court analyzed the totality of the evidence in the case, including the expert witness testimony, and it found “most relevant and persuasive” the comparable pay by comparable concerns, the C corporation’s distribution history, the setting of Mr. Hood’s compensation in the years at issue, and Mr. Hood’s involvement in the business. The court concluded that a reasonable wage expense for 2015 and 2016 was $3.7M and $1.4M, respectively. As a result, the corporation was unable to deduct the “unreasonable” portion of the compensation paid to Mr. Hood and it owed corporate tax on such amounts.
Qualified Business Income
Since the passage of the TCJA, pass-through entities like S corporations enjoy a 20% deduction on their qualified business income (QBI). This deduction was intended to lower the rate of tax applicable to income from pass-through entities because the top tax rate applicable to C corporations was reduced from 35% to 21%. The QBI deduction is scheduled to disappear after 2025, though it could be extended by Congress before that time.
The reasonable compensation issue plays a role in the QBI computation because S corporation shareholders are allocated a pro-rata share of the S corporation’s QBI and such amount is determined after the deduction of reasonable compensation. It also plays a role in determining the amount of a QBI deduction limitation that restricts the benefit of the QBI deduction in cases where the amount of the deduction exceeds a defined amount of wages paid and capital investment i.e., the so-called W-2 wages/UBIA limitation.
The impact of reasonable compensation on the QBI deduction is not always easy to determine. This is because the greater the amount of the wages paid, the lesser the amount of the QBI deduction and the lesser the amount of the W-2/UBIA limitation. Conversely, paying reduced wages results in a greater QBI deduction and W-2/UBIA limitation.
As if that weren’t enough, there is the excess business loss (EBL) limitation to consider.
Excess Business Loss
The EBL limitation also came into effect as part of the TCJA and was originally scheduled to expire after 2025; however, the CARES Act postponed it through the end of 2020, and the American Rescue Plan Act of 2021 extended it through 2026.
The EBL limitation generally limits the ability of non-corporate taxpayers to deduct losses in excess of specified threshold amounts; in 2022, the limits are $270,000 for single filers and $540,000 for joint filers, and these limits are adjusted annually. Specifically, the EBL limitation applies to the amount by which (i) the taxpayer’s total amount of business deductions in excess of the total amount of gross income and gains attributable to such businesses (disregarding the QBI deduction) exceeds (ii) the threshold amount. Any EBL is treated as a net operating loss (NOL) carry over to the following tax year, so it is a timing provision rather than a disallowance provision.
Reasonable compensation impacts this computation because the greater the number of wages paid, the lesser the loss and the greater the amount of the potential EBL limitation. Similarly, the lesser the amount of wages paid, the less likely the EBL limitation is to apply.
So let’s try and put it all together using an S corporation as the example. In general (and there definitely are exceptions), the greater the number of wages paid to shareholder-employees, the greater the amount of employment taxes, the lesser the amount of the QBI deduction and W-2 wage/UBIA limitation, and the more likely the EBL limitation is to apply. Conversely, paying fewer wages reduces employment taxes and potentially increases the QBI deduction, and reduces the chances the EBL limitation would apply.
As can be seen, things can get confusing pretty quickly. Taxpayers and practitioners alike are often confounded by the issue of reasonable compensation. It is a sticky wicket. But with careful planning and qualified tax advice, it is an area of uncertainty that can be managed.