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Are you Overpaid?

By October 1, 2000July 12th, 2023Management and Leadership7 min read

Most people would answer that question”NO!” very quickly. But in the case of an owner of a business, who is also an officer of that business, the IRS may have a different view.

The reason that the IRS argues that employees of businesses are overpaid has to do with the way “C” corporations are taxed. A corporation pays corporate income tax on its net income …. the income that it earns, less all of its expenses. One of the expenses that is deducted from a corporation’s income is compensation (salary), paid to an officer. Office compensation is deductible even if that officer also owns the corporation. Which is frequently the case with closely held corporations. The more compensation a corporation pays to its officer, the less corporate income tax it pays.

By way of background, a “C” corporation pays income tax on its “net income.” Compensation (salary or bonuses) paid to an officer is deductible as compensation expense, even if that officer also owns stock in that corporation. The more compensation a corporation pays to its officers, the less corporate income tax it pays. On the other hand, dividends paid by the corporation to its shareholders are not deductible. Therefore, to the extent that a corporation pays dividends, rather than salary, to a shareholder/officer, the corporation constructively is subject to tax on the dividend expenditure. The shareholder (individually) is also subject to income tax on the dividend. Thus, the nondeductibility of dividends paid to shareholders effectively causes a “double tax.” In light of the above, it should not come as a surprise that the strong preference of the IRS is that some portion of the money paid to a shareholder/officer be in the form of a dividend, rather than salary, in order to create a “double tax.”

There has been a considerable amount of litigation over the reasonableness of salaries paid to the shareholder/officer and case law (sometimes called “excess compensation” or “unreasonable compensation”) cases have evolved over time. The “excess compensation” question has never applied to professionals such as doctors and attorneys.

In the 1960s and 1970s the courts developed a series of “tests” or factors that they consider determined if the compensation paid to the shareholder/officer was “unreasonable.” The test required the court to determine such things as “the type and extent of the services rendered,” or “what an unrevealed third party would pay a comparable employee for the same services notwithstanding the fact that he is also a shareholder.” By the early 1980s, there were more than 15 recognized tests. Worse still, was the fact that their tests were subjective and therefore open to different interpretation by the courts. By the mid-to-late 1980s, changes to the tax code and the slow down in the economy made the issue of excess compensation less pressing.

However, as the economy rebounded in the 1990s, the IRS began actively trying “unreasonable compensation” cases again. Fortunately by then, the courts had begun to analyze the questions of owner’s compensations in a more logical and objective fashion. The new analysis, offered by the seventh circuit in Exact Spring Corporation v. commissioner (November 16,1999), holds that the question of the owner compensation should be viewed through the eyes of the shareholder as an investor, rather than just focusing on the amount of compensation paid to the owner. Investors want an adequate rate of return on the investment to compensate them for the risk of the investment.

An investor, as an owner, gets his return on an equity investment from two sources. The first is through dividends paid on the stock and the second is through worth in value of the corporation’s stock “capital appreciation”. Under the courts new test, if the owner, as an investor, receives an adequate return on his equity investment by virtue of the combination of dividends from the corporation and stock appreciation, then the compensations paid the officers are presumed to be reasonable. The presumption is made even where the shareholder and the officer are the same person. Conversely, if the shareholder’s return on equity is less than what it should have been over time, there is a presumption that the salaries paid to the officers are excessive.

In the case of the family-owned business the new analysis presents several challenges. The first is that family business seldom declares dividends. Thus, capital appreciation is the only element that gives rise to a shareholder’s return on equity. But, by definition, there is no “public market” for the stock of a family business which would allow the owner to determine what the fair value of the corporation was at any given point in time.

The question of reasonable compensation turns on what the value of a family business is now and how much has it increased since the owner purchased it. When there are certain objective analyses that should be applied in all situations, the valuation of a family business can be complex, and valuation experts frequently disagree. At best, experts can agree on a “reasonable range” of values but many times experts cannot even reach a consensus on the fundamental point.

The second challenge that the new test presents is what rate of return on equality must the investor receive in order to have an acceptable rate of return. Investors normally require a rate of return on an investment equal to the risk that they assume. US Treasury bonds are usually considered “risk free” since there is almost no chance of default. The risk of a US Treasury bond is measured by the interest rate that investors require before they will purchase the bond.

Presently the 20-year US Treasury bond rate is around 6.5%. The rate on return that investors require from large publicly traded companies is equal to the risk-ree rate (the US Treasury bond rate) plus some premium (sometimes refereed to as the “equity risk premium”), to compensate for the fact that equity investments are inherently more risky than bonds. Currently, the equity-risk premium for large public companies is about 8%

Beyond these two considerations, an investor right require a higher rate of the return because a family business has more risk, in terms of future cash flow and long term stability, than a large publicly held company. The additional amount of return that an investor would require over the 14.5% (6.5%+8%) rate is subject to debate. The general wisdom is that an investor usually requires between 15% and 25% rate of return for an investment in a family business. Although there is little agreement on how the rate should be calculated within this range.

Once the value of the family business is determined and the rate of return over the time that the shareholder has received on their investment is calculated, this rate is compared to what the investor would normally require on a similar investment. If the rate of return is adequate, then the compensation paid to the officers is presumed reasonable.

In light of the above, the following proactive steps will help protect your family business from the IRS challenge to owners compensation:

  1. Strong consideration should be given to establishing a method or formula for determining an officer’s compensation. In excess compensation, the courts have not been inclined to challenge the compensation paid to an owner if it is consistent with a long-standing and economically sensible formula or method. If the corporation has a method it follows over time that correlates the corporation’s performance with compensation paid to officers, the IRS is less likely to successfully challenge compensation.
  2. The corporation should consider declaring dividends if the situation warrants. If the corporation is very profitable and the cash is not needed for some other valid business reason, then declaring dividends may be appropriate. Historical studies show that over the last 15 years, the vast majority (between 80% and 90%) of the return that investors receive from an equity investment is from capital appreciation, not dividends. Thus, dividends do not have to be a big portion of the return on the investment. From an audit standpoint, the IRS will have a difficult time making the excess compensation argument if the corporation has declared dividends.
  3. Consider having the corporation elect “S” status. An “S” election is a special election that a regular “C”
    corporation can make such that the corporation does not pay any corporate income tax. Any net income that the “S” corporation makes, flows through the shareholders and is taxed on them personally. Since there is no “double tax” possible with the “S” corporation, the IRS cannot raise the excess compensation issue. An “S” corporation and taxation of its shareholders is very complex and there are some negative aspects to an “S” election. Careful analysis should be undertaken before an “S” election is made.
  4. Finally, if an owner has received a substantial salary and the corporation does not have a compensation formula, or a history of declaring dividends consider obtaining a professional evaluation. A professional evaluation will help determine if there is a problem. A professional evaluation will also help you decided what steps you might take in order to prevent a problem. A proactive change in compensation and dividend policy prior to an IRS audit will sometimes discourage the IRS from making the “excess compensation” argument.