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Reasonable compensation in closely-held corporations
Generally owned by a single or small number of shareholders, an overlapping identity exists between those who own closely-held corporations and those who work for them. Taxand USA explores reasonable compensation in the context of these corporations and what they can do to prepare for an inevitable IRS audit.
Closely-held corporations should consider instituting written policies that provide an objective basis for how compensation and bonuses are determined for both shareholder and non-shareholder employees. If feasible taxpayers should also consider engaging third-party service providers to conduct compensation benchmarking studies.
With respect to bonuses paid to shareholder-employees closely-held corporations should document why the particular shareholder-employee is receiving the bonus and should also consider tying bonus payments to the achievement of certain objective metrics. Bonuses awarded to shareholder-employees that track or mirror stock ownership should be avoided.
Policies can only be an effective deterrent to potential reasonable compensation disputes if they are in fact followed. It is understandable that some closely-held corporations are run with varying degrees of formality which may extend to setting compensation and determining bonuses paid to employees, including shareholder-employees. The court considers highly-structured and well-established compensation plans to be a positive factor in evaluating whether compensation paid to shareholder-employees is reasonable.
Reasonable compensation audits can be expensive, time-consuming and distracting. Unfortunately, more can be expected as the IRS is using various schemes and devices that are used to extract corporate earnings under the guise of compensation. There is also increased speculation that the IRS may look at monitoring fees or management fees paid to private equity firms as another form of disguised dividends and apply a similar test to determine reasonable compensation. It is therefore never too soon for taxpayers to begin implementing measures that may reduce the likelihood of reasonable compensation being raised as an issue in an IRS audit.