Reasonable Compensation & the Family Business
Ensuring the Price is Right
The heart of a family business is working with family members or including them in the company ownership. And while The Tax Cut and Jobs Act certainly made it easier for families to pass on their wealth through a family business, it’s important to remember that closely held businesses are often subject to increased scrutiny from the IRS, particularly with regard to the compensation of family members.
“Working alongside your loved ones in your family business can be very rewarding, but caution needs to be exercised to ensure the financial rewards in the form of salary and bonuses are reasonable and tied to the value of the work performed,” says my colleague, Mary Ellen Kreuger,” a director in wealth management and partner at Aspiriant.
Because of the emotional and intimate nature of familial relationships, there’s an assumption that a payment to a relative is not an arms-length transaction. The IRS sees this as a red flag and pays close attention to any amount of money paid to a relative and deducted as a business expense. The government is primarily concerned that such payment may be a gift or, if the relative is also a shareholder, a disguised dividend.
Under §162(a)(1) of the Tax Code, a business may make an income tax deduction for employee compensation, provided such compensation is both reasonable and paid for personal services actually rendered. These requirements have been set in order to deter potential tax evasion schemes. For example, a business owner desiring to give a large sum of money to a loved one may attempt to disguise this gift as compensation, effectively taking a business deduction on the transfer while circumventing gift tax consequences. Thus, the tax law requires that any payment of compensation is legitimate.
While it’s fairly simple to determine whether an employee has provided services to a company, assessing the reasonableness of that employee’s pay is much more challenging. As a result, many court cases hinge upon the latter issue.
What is “reasonable” compensation?
Unfortunately, there is no hard-and-fast rule used to validate the reasonableness of employee compensation. Each decision is made based on the unique facts and circumstances of the case. Furthermore, the courts have famously adopted differing methods of analysis. Many jurisdictions have put together a multi-factor test, while others attempt to create an objective standard to establish reasonableness, and some use a combination of the two.
The multi-factor test was established in the seminal case of Mayson Manufacturing Co. v. Commissioner in 1949. This case inspired many other courts to use varying versions of the Mayson test, some taking into account 21 separate factors, such as:
- The employee’s background, experience and knowledge of the business
- The employee’s contribution to profit-making
- The time devoted by the individual to the business
- The prevailing economic conditions
- The employee’s position and responsibilities
- The time of year that compensation is determined
- Ratio of stockholdings to earnings
- The compensation paid by similar businesses to comparable employees
- Compensation paid in prior years
Other courts have criticized the Mayson test, arguing that, because it is too subjective and difficult to apply, it produces arbitrary results. This notion brought about the use of the “independent investor” test, as introduced in an equally notable case, Exacto Spring Corp. v. Commissioner.
Independent Investor Test
The independent investor test is an attempt at implementing a more objective basis to assess the reasonableness of the compensation. In order to satisfy this test, the business owner must prove that a disinterested investor would approve of the compensation amount, after taking into account the return on investment and potential for dividends after compensation is paid.
Because there is no bright-line rule to refer to, both tests provide important guidelines for making compensation-related decisions.
“As a practical matter, as long as the family member is qualified to perform the job, actually shows up for work and is paid an amount commensurate with their predecessor, others working in a similar capacity or their prior compensation from third parties, it will be difficult for the IRS to successfully challenge the reasonableness of their compensation,” summarizes Raymond Edwards, Aspiriant’s National Technical Tax Director.
Possible consequences of unreasonable compensation
In the event your company has been found to have paid unreasonable compensation to an employee, it’s important to understand that consequences may not be borne solely by the business. In fact, you and other shareholders of your company may be subject to personal tax liability. The outcome depends on the court’s recharacterization of the transaction in question, which may be based upon the actual intent behind the transaction, as well as other factors.
If the court finds that the true intent behind a payment is not to pay for work, but rather to make a gratuitous transfer, it may determine that a partial gift has been made with respect to the unreasonable portion of the compensation. In this case, your company will be denied the deduction it took for the “gift.” Because businesses are not subject to gift taxation, Treasury regulations specify that any gift made by a corporation is considered to be made by the shareholders for gift tax purposes. Thus, you and any other owners will have to pay the gift tax.
In practice, however, courts tend not to recharacterize unreasonable compensation as a gift and instead hold that the form of the transaction is a distribution of profits. This is because the court will find an intent to compensate, due to the fact that the business has held out the payment as a salary or other type of pay for performance.
If your business is a C Corporation, it is likely that any overpayment to a shareholder employee will be characterized as a disguised dividend. Because C Corporations are subject to double taxation, the IRS will argue that the shareholders are attempting to lower the tax liability of the corporation by characterizing sums of money that should be non-deductible dividends as salary or wages, thereby creating large business expense deductions when filing the corporate tax return. If the court agrees, the deduction for the portion of payment considered to be a dividend will be disallowed and the recipient of the payment may need to make adjustments to their tax liability, as dividends and salary are not necessarily taxed at the same rate.
Special issues for S Corporations
S Corporations find themselves with an entirely different issue to worry about — that of underpaying their shareholder employees. In an S Corp, owners are personally liable for the company’s income. This lowers the incentive to make business income tax deductions for salaries, because the owner will be taxed regardless (either as business income or personal income). Instead, the IRS will argue, an S Corp may attempt to evade payroll taxes by treating an amount that should be salary as an owner distribution and paying the owners extremely low salaries. If the court agrees, the company will be on the hook for additional payroll taxes, penalties and interest.
How to protect your business from compensation challenges
So how do you best protect your company, your family and yourself from future challenges related to compensation within your family business? The tips below will help to demonstrate that compensation paid is legitimate:
1. Establish a universal compensation-setting method or formula, applicable to all employees. This method should address both salary and the bonus structure of your company. Never pay bonuses to shareholders in proportion to their ownership interest, as this will appear to be a disguised dividend. Consider setting bonuses at the beginning of the fiscal year, before you have information as to the profitability of the company for that period.
2. Work with an independent valuation or compensation analyst to determine the reasonableness of your employees’ compensation. This can provide helpful support in the event of an IRS audit.
3. If your company is an S Corp, use caution when assigning job titles to your family members. Though it may be tempting to give your loved one a glamorous title, the IRS will look at comparable salaries for others who appear to have the same job. If your relative is paid considerably less than market value, your company may get a visit from the IRS.
When all else fails, look back at the multi-factor and independent investor tests mentioned above. They will give you insight into considerations to keep in mind when setting compensation for your family member.
Mary Ellen adds, “Our clients find it valuable to have their entire team of experts — CPA, wealth advisor and attorney — all sitting at the table working together to identify potential issues and planning opportunities to ensure you can worry less about tax issues and keep your focus on running your successful family business.”
1United States Tax Reporter, ¶1624.212 Compensation Payments to Relatives.
2Barbara F. Sikon, Recharacterization of Unreasonable Compensation: An Equitable Mandate, 51 Cleveland State Law Review 301 (2004).
3Treas. Reg. 1.162-7(a).
4Melvyn Poswolsky, Assuring the Deductibility of Compensation in a Closely-Held Corporation, 18.3 Journal of Corporate Taxation (1991); See also Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir.1949).
5Sikon, supra note 2 at 12-13.
6Rapco Inc. v. Commissioner, 85 F.3d, 950, 954-955 (2d Cir. 1996).
7Garrison v. Commissioner, 52 T.C. 281, 285 (1969); See also Sikon, supra note 2 at 16-20.
8Treas. Reg. §25.2511-1(h)(1).
9Garrison, 52 T.C. at 284.
10Smith v. Manning, 189 F.2d 345, 348 (3d Cir. 1951).
11Internal Revenue Service, Job Aid for IRS Valuation Professionals. Please note that this resource was created for information purposes and may not be cited as legal authority.
12Saul Levmore, Recharacterizations and the Nature of Theory in Corporate Tax Law, 136 Pennsylvania Law Review 1019 (1987-1988).
13Robert M. DiGiantommaso, Items and Factors to Consider in Setting Reasonable Compensation, The Tax Advisor (2018).
14William Barnard, The Unreasonable Compensation Issue Rises from the Dead and Takes on the Independent Investor, 93 Journal of Taxation 356 (2000).
15DiGiantommaso, supra note 13 at 2.