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For many years, C-Corporation and S-Corporation have struggled with the requirements of “reasonable compensation” for employee shareholders in section 162 of the internal tax code. For C-Corporation, the question arises when there are differences in the classification between compensation in the form of wages for services rendered and dividends. Dividends, unlike wages, are subject to double taxation; once at the corporate level, and then again at the shareholder level. However, wages are corporate deductible and transfers tax liability to employee shareholder. This leads to an incentive to pay unreasonably high wages, so income is taxed only at the shareholder level and a deduction at the corporate level. On the contrary, there is an incentive for shareholders of the S-corporation to pay a small salary or not to pay it at all due to the fact that wages are subject to employment taxes in the form of social security and Medicare, and ordinary income transferred to the shareholder as “profit distribution "Is not, but only taxed for income tax purposes.
questions
Section 162 of the code allows you to subtract "reasonable" compensation, but can not define this term. Taxpayers reserve a protected position and define "reasonable" for themselves. The problem is that the IRS and the taxpayer many times disagree. As a result, there were many cases that were the subject of legal proceedings, to come to terms with the ambiguity of the law and allow the courts to decide. Because of these court cases, sensible cases were better defined, although transparency still remains a problem. Litigation gave advice to taxpayers; however, each situation is so different that it is impossible to compare apples with oranges and make a firm decision. Many taxpayers, on the recommendation of their CPA, use the so-called “60-40” rule. First, it should be understood that this is not the IRS rule. It has been developed by practitioners as a simple guide for determining a reasonable salary. The IRS did not publish any statements that this is a “safe haven” for paying salaries to the Shareholder-employee, and there is no regulatory or judicial authority that justified it. According to approach 60-40, the difference between salaries and dividends should be 60% for salaries and 40% for dividends of profits or dividends. For example, suppose the taxpayer is the sole holder in his S-corporation and works full time. During the year, he receives $ 100,000 in hands from the corporation. His salary should be $ 60/40 x $ 100,000 = $ 150,000. Although this is only one interpretation of the rule, suppose that dividends are not produced from the corporation over the same year. Instead, he “throws away” the profits to the corporation for future needs. Does this mean that there are no reasonable salary requirements? If a reasonable salary is $ 150,000, when there are dividends, then a reasonable salary is $ 150,000 if there are no dividends. Also, why use a 60-40 split? Why not split 50-50 or 30-70? The 60–40 approach is an arbitrary rule, and many taxpayers are very optimistic about the aggressive attitude they are taking, and many of these ideologies receive from their tax preparers. In fact, many tax collectors use net interest across the board, regardless of specific facts. Perhaps the more logical rule is that wages be a percentage of the net income of a corporation’s business before considering a wage deduction, for example, from 30% to 40%. Suppose that the taxpayer in the example above, before deducting his salary, the net income from the corporation’s business is $ 250,000. Reasonable wages for him can be $ 100,000 in these circumstances, regardless of distribution. You can also characterize the wages as a percentage of gross income, since this means that the net profit exceeds the sum of the activities and obligations of the shareholder. The problem still lies in the fact that there is no “rule” or set of guidelines for a specific definition of what is reasonable compensation and, perhaps more importantly, not.
Power
Section 3121 (a) of the section defines wages as “all remuneration for work” for the purposes of a federal employment tax. Section 3121 (d) defines an employee in part as any corporate officer. There is an exception, however, with Reg. Section 31.3121 (d) -1 (b) for officials who do not perform or provide services only. (B) (3) reads: “In any case, the premium for the paid compensation cannot exceed the normal payment for similar services by similar enterprises in all circumstances under the same circumstances.”
In Devine Brothers, Inc., TC Memo 2003-15, the corporate president received compensation for the tax year in the amount of $ 260,378. The IRS rejected the $ 65,000 deduction as unjustified compensation. The tax court approved, on behalf of the taxpayer, the decision that the employee was underpaid in previous years, and a higher wage was justified as payment. This case demonstrates the processes and procedures that the courts use to determine reasonable. In this particular case of previous years, compensation has been added to the formula. EJ Harrison and Sons, 101 AFTR 2d 2008-1298 - a case where the IRS reclassified dividend payroll. In this case, the Director-General worked full-time and was paid in 1995, 1996 and 1997 in the amount of $ 860,000, $ 818,000 and $ 600,000, respectively. She served on board, represented the company at numerous charity events, and she personally guaranteed a credit line. The IRS refused to deduct most of the salary, claiming that the services of the CEO were equivalent to those provided by an outsider acting as chairman of the board of directors, and only allowed to deduct salaries of between $ 54,000 and $ 59,000 each year. (EJ Harrison and Sons, TC Memo 2003-239). The Ninth Circuit Court of Appeal disagreed with respect to comparison with the outsider, and returned the case in order to reduce reasonable compensation. The tax court then found the compensation reasonable out of all actual compensation and rewarded over the years (EJ Harrison and Sons, TC Memo 2006-133). This decision of the tax court was confirmed by the 9th district (EJ Harrison and Sons, 101 AFTR 2d 2008-1298). This case demonstrates the use of the definition of actual services rendered, the comparative salaries of comparable services from comparable corporations. It also demonstrates the complexity of the decisions and illustrates the fact that the definition of reasonable compensation is very subjective and amenable to continuous litigation. Conclusion / Recommendation
Several decisions of the tax court focused on various factors due to the opacity of the character and the many variables that must be considered to determine “reasonable” in this case. Some of these considerations include:
- The nature and financial condition of the corporation
- The role played by the employee shareholder in the corporation, including position, hours worked, and responsibilities
- Corporate compensation policy for all employees and the history of paid wages to shareholders, including their consistency
- Comparison with similarly located employees of other companies of past cases
- Regardless of the hypothetical, an independent investor has concluded that there is an adequate return on investment after considering the shareholder’s compensation
- A history of corporate disputes • Salalah versus distributions and retained earnings
- General economic conditions
- Comparison of salaries paid through sales and net profit
- Size and complexity of the business
Conclusion
In establishing reasonable compensation, no single factor controls the decision-making process; rather, a combination of factors must be considered. In addition, these factors are not comprehensive and cannot be the same. Each situation is different and can be without precedent. When justifying wages, the taxpayer must take into account all the facts. Although there are few indications regarding the determination of reasonable compensation, and in combination with a clear incentive to lean towards the high or low side of the reasonable, the courts seem to prefer taxpayers who can justify the funds by providing the necessary documentation confirming their decisions. In addition, court cases that are against the taxpayer, usually represent a situation where the taxpayer is clearly unfounded and does not head the line. Some forms of justification, however, may require more forms, access the Internet on websites that publish fair market values based on location and location, such as http://www.salary.com, compared to industry standards and benchmarks. , examining tax court cases and income decisions. Regardless of how the rationale is made, it should be understood that the position that a position can take can and can be challenged when the position is extremely upside down. Reasonable matters to everyone in different ways, and in general, the accepted definition will reflect the personal interests of the receiving party. In conclusion, all aspects and facts regarding reasonable wages paid to the employee shareholder should be considered in order to determine a justified and justified position. There are reasonable methods for determining what is reasonable, but all positions must be carefully documented and carefully considered.
