The IRS continues to routinely scrutinize executive compensation. Everyone should know that this is a particular area of interest in audits. Closely held C corporations are the most vulnerable to IRS scrutiny. If they have overpaid their shareholder employees, they are only allowed to deduct reasonable compensation paid to shareholder-employees.
On the other hand, S corporations are scrutinized for underpayment of shareholder employees. By setting their payment unreasonably low, shareholders may increase their profit distributions and dodge payroll taxes. Obviously, this is not an acceptable attempt to save on taxes. The key is that executive pay must be reasonable. The IRS bases its determination of reasonability on comparability data.
To avoid problems, it is crucial to document executive qualifications, duties, and major accomplishments. Qualifications extend beyond education and experience, and should be fairly detailed. Take into account professional reputation and leadership ability. This can make the process smoother in the event of an audit.
Executive Compensation For C Corps
If owners are underpaid during slow periods of cash flow, they may be eligible for catch-up pay when the company’s cash-flow is better. However, this should be documented in a written compensation plan in advance. Keep track of the individuals who approved this.
Compensation plans should include a method of determining incentive amounts. Bonuses should be performance-based. In addition, non-shareholders and non-family members should also be considered for bonuses, thus preventing bonuses that act like dividends. Paying small dividends can also separate bonuses. from looking like dividendsThese incentives should be clearly tied to company goals. To avoid problems, base bonuses on growth rate or net income, rather than on the cash balance.
Another red-flag for the IRS is the retirement of a key employee. The gradual exit of a pivotal employee should be accompanied with a decrease in pay corresponding to decrease of responsibility. This can be a difficult issue to discuss. However, it is critical to ensure that pay is in keeping with employee responsibility, since any excess executive pay could be recharacterized as dividends.
Executive Compensation For S Corps
Using empty (but formal-sounding) titles for family members who are not major players in the family business is a hidden danger for S Corps; the IRS actually looks at those titles when looking at comparability data. As stated previously, the IRS scrutinizes underpayment of employees in S Corps; the titles could be a red flag.
Adjusting a shareholder’s pay could incur penalties for failure to withhold and deposit taxes or result in disproportionalized distributions.
Even if shareholders receive no compensation, filing payroll tax returns (even if there are no actual numbers, only zeroes) can avoid the penalty for failure to file payroll returns if the IRS determines that there should have been compensation. Obviously, there will still be consequences for any errors in payroll returns.
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This posting is intended to provide generalized information that is appropriate in certain situations. It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer. The contents of this posting should not be acted upon without specific professional guidance. Please call us if you have questions.