So, What’s Reasonable Compensation Anyway?
Have you ever wonder what an adequate wage is for an owner of a small business? The
answer is not as easy as looking it up in a book or in the classified section of the newspaper. The determination as to whether an individual’s compensation is reasonable is based on the specific facts and circumstances surrounding the payments. It involves looking at all aspects of the business and the owner’s role – much like what is considered in business valuations. Tax problems can surface if the compensation is too high, too low, or not payment purely for services.
A corporation is allowed a deduction for compensation only if the amount paid is reasonable. “Reasonable” compensation becomes more questionable when it involves a shareholder/employee who is personally performing the very services from which the compensation is earned.
What Factors Constitute Reasonableness?
There is no rigid set of rules for measuring the reasonableness of compensation and no definition of “reasonableness” exists. The regs provide only that reasonable compensation is an amount paid for like services by a like enterprise under like circumstances. Court cases have shown, however, that an individual’s compensation is reasonable based on the specific facts and circumstances surrounding the payments.
The determination of reasonableness involves more than just an analysis of the amount of cash paid to each employee. Although the IRS usually places more emphasis on cash payments, in certain cases, the amount of noncash compensation also receives IRS scrutiny, especially when the noncash compensation represents a substantial benefit to the employee. The use of noncash compensation (also known as “fringe benefits”) requires careful tax planning. In a C corporation, the cost of a fringe benefit generally is deductible at the corporate level, and the employee who receives the benefit excludes the value from income. In an S corporation, however, fringe benefits paid on behalf of a greater-than-2% shareholder are subject to special rules and are usually treated as additional wages to the shareholder, subject to payroll taxes.
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