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IRS Challenges Due to Unreasonable Compensation

Reasonable compensation issues can come up in a variety of circumstances. An IRS tax audit may result in an adjustment to your compensation or the compensation of your employees, causing you to owe additional taxes, penalties, and interest.

The IRS may challenge the reasonableness of compensation in any of the following situations.

Reasonable Compensation in Family Businesses

Reasonable compensation issues can come in family businesses that employ children, grandchildren, or other relatives. If you increase your relative’s salary, you receive a tax deduction for their wages. You also accomplish a transfer of wealth to the next generation without using up your gift tax exemptions.

The IRS can disallow these deductions if the salaries are unreasonable. This standard is discussed below in more detail.

C Corporations

The owner-employee of a C Corporation has an incentive to pay themselves a high salary. Salaries are a deduction for the corporation, while dividends are not. Either way, the owner receives the money, but one offers a distinct tax advantage.

S Corporations

Owners of S Corporations have the exact opposite incentive. They may wish to reduce their salaries as much as possible because salaries as subject to self-employment taxes, while shareholder distributions aren’t.

If your salary is far below industry standards, the IRS may take a closer look at your tax return, especially if you have substantial shareholder distributions.

Determining Reasonable Compensation 

The IRS and the courts may consider many factors when determining if compensation is reasonable, including:

  • the employee’s qualifications
  • the type and amount of work completed by the employee
  • the proportion of compensation to distributions to shareholders
  • prevailing rates for similar businesses in the same industry
  • comparison of current compensation to compensation in prior years

When in doubt, treat a compensation decision as if the party was involved in an arms-length transaction. You should also have a plan to determine compensation in place beforehand, so you don’t have to come up with an explanation for your decision after-the-fact.

If the IRS is challenging the reasonableness of your compensation or the compensation paid to your employees, contact a tax attorney to discuss your case. 

Get help with reasonable compensation disputes by calling The Gartzman Law Firm at (770) 939-7710. We can listen to your concerns and help you find the best tax resolution strategy for your case.