Closely held corporations compensation issues
Published October 14, 2020

Closely Held Corporation Shareholder Compensation—Are You Too Close for Comfort?

The inevitable and sometimes uncomfortable conversation about compensation—some approach it with anticipation, others with dread. In most instances, the issue is relatively straightforward—employers offer and pay salaries they deem appropriate. However, for shareholders in closely held corporations, the issue becomes more sensitive, particularly where the Internal Revenue Service (IRS) is concerned.

Why Compensation for Shareholders of a Closely Held Corporation Matters

The IRS does not question the amount of compensation paid for every employee in every situation, but it does consider compensation paid to shareholders of closely held corporations, because it is aware of the opportunity to pay shareholders through tax-free means that should more appropriately be considered salaries and wages. The IRS generally describes a closely held corporation as a corporation that meets all these criteria:

  • Is taxed as a corporation.
  • Has more than 50% of the value of its outstanding stock owned (directly or indirectly) by five or fewer individuals at any time during the last half of the tax year.
  • Is not a personal service corporation (broadly defined as a corporation whose owners perform personal services, such as accounting, actuarial science, architecture, consulting, engineering, health—including veterinary services, law firms, and other similar services).

 

Internal Revenue Code (IRC) Section § 162(a)(1), provides that “a reasonable allowance for salaries or other compensation for personal services actually rendered” shall be allowed as a deduction during the taxable year, in carrying on any trade or business. For closely held corporations, the main word in IRC §162 is reasonable. There are several factors to consider when determining the reasonableness of compensation rendered to a shareholder of a closely held corporation. Consider the following:

  • Would an objective, independent third party consider the compensation reasonable?
  • Is the compensation solely for services rendered to the corporation employing the shareholder?
  • Has a recent study been performed to determine compensation benchmarks for the position held by the shareholder?
  • Are distributions or dividends to shareholders reasonable, when considering base compensation and its reasonableness?
  • Is the compensation for use in loan repayment to a shareholder?

Taxpayers should be aware that the IRS has historically focused on compensation matters when auditing closely held corporations. Both excessive and diminutive salaries pose risks to taxpayers. Some examples of each are below.

Risks posed by compensation that is potentially too high

  • The IRS could deem a portion of the compensation “ineligible” for a tax deduction.
  • Higher compensation could be disguised dividends, resulting in reclassification under audit.
  • If compensation expense is significantly reduced during an audit, the taxpayer could incur accuracy-related penalties.

Risks posed by compensation that is potentially too low

  • Lower amounts could be deemed unreasonable and lead to understated payroll and unemployment tax calculations. If that determination is ultimately made, a taxpayer could face fines and penalties for underpayment of those taxes.
  • Excessively low compensation could impact an individual’s Social Security and disability eligibility at retirement.

Whether you are forming a new closely held corporation or have been in business for many years, there is no better time to examine shareholder compensation levels to ensure reasonableness and compliance with current IRS regulations. Both the corporation and the individual shareholder should get ahead of the game to set and document reasonable compensation.

If you need assistance determining appropriate compensation levels for your business, contact a PYA executive below at (800) 270-9629.

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