A business may reduce its’ corporate income by paying employees a wage. If you work for your business, then you may deduct a reasonable salary as a business expense. Even the president and sole owner of a closely held corporation is considered an employee for tax purposes.[1] Fortunately, IRC §162(a) and Reg. §1.162-7, permit employers to deduct reasonable salaries or compensation paid to their employees, as a business expense. However, businesses cannot use unreasonable compensation to offset corporate income. What determines reasonability? Under Reg. §1.162-7(b)(3), “reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” Taxpayers bear the burden of proof to justify the deductions they claim. So, how do you determine and defend your compensation? You must consider the individual facts and circumstances, strategize for deductibility, and anticipate potential tax consequences.
To determine a reasonable salary, you must subjectively consider the relevant facts and circumstances of the employee in question. There is no definite test for reasonability. Whether your salary is reasonable will, typically, depend on:
- The skill and education required to manage your business;
- The economic conditions of your industry and the area in which you work; and the
- Risks and duties of your position; and
- The owner’s expected return on investment.
Reasonable compensation is what you would ordinarily pay a suitable individual for one’s work. It would help if you documented these or similar considerations when setting your salary, not after you start paying yourself. Executing a formal, written, employment contract makes your salary a deliberate business decision (and you will not scramble to explain your pay to the IRS retroactively). Moreover, a reasonable salary may also depend on how it affects profits.
Under IRC §162, if an expense was to support or expand the business, then the IRS will generally regard the cost as necessary and therefore reasonable. Once the payment is reasonable, it becomes deductible. Therefore, businesses may deduct fair salaries when services are rendered. If a corporation pays a shareholder-employee an excessive salary then, “…the excessive part of the salary may be treated as a constructive dividend to the employee-shareholder. The excessive part of the salary would not be allowed as a salary deduction by the corporation.”[2] In Heitz v. Commissioner, employee-owner William Heitz paid himself $1.3 million and $1 million in 1993 and 1994. The IRS argued that these amounts were excessive. The Tax Court ruled that Mr. Heitz could deduct salaries of $900,000 and $700,000 for the years at issue, added the difference to the company’s income, and assessed a deficiency against the business.[3] However, in Exacto Spring Corp. v. Commissioner, (the successor case) the U.S Court of Appeals for the Seventh Circuit held that a salary is presumed to be reasonable if the other owners earn their expected return on investment and reversed the Tax Court’s earlier decision (therefore Mr. Heitz’s compensation was not excessive, and the company could deduct it as a business expense).[4] As with Mr. Heitz, tax attorneys are essential to defending your deductions.
Next, you must anticipate the tax consequences of your compensation. You may pay yourself in wages, take a distribution or dividend, or both, but all three are taxed differently. Depending on your corporate structure, your payments may be subject to self-employment taxes or payroll taxes on income from your business. Dividends and corporate distributions are taxed at capital gains rates (up to a Federal rate of 23.8%). How you defend your compensation affects whether you evade fines and penalties.
In sum, as an employee-owner, you may deduct a reasonable salary as a business expense. Reasonable compensation is what someone with your similar skills would expect to be paid, considering the relevant facts and circumstances, for the work required. Strategically planning for the deductibility and tax consequences of your remuneration will mitigate your tax liability. Work with STA’s experts to determine your optimal reasonable salary.
[1] Rev. Rul. 71-86, 1971-1 C.B. 285 (IRS RRU 1971).
[2] https://www.irs.gov/publications/p535#en_US_2018_publink1000208662.
[3] Heitz v. Commr., 75 T.C.M. (CCH) 2522 (Tax 1998), Rev’d Sub Nom. Exacto Spring Corp. v. C.I.R., 196 F.3d 833 (7th Cir. 1999).
[4] Exacto Spring Corp. v. Commr, 196 F.3d 833, 839 (7th Cir. 1999).
