The IRS is increasing scrutiny of executive compensation, and executives are often shocked when the IRS challenges their pay. While the IRS has the power to levy extra taxes on pay that it deems unreasonable, following a few steps can prevent or defeat these challenges. Executive compensation should be carefully documented, detailing each key employee’s qualifications, responsibilities, and major accomplishments. Documentation should go beyond the obvious items such as experience and education to include more intangible aspects such as the executive’s reputation, connections within the industry, and communications skills. Additionally, other important intangibles such as examples of leadership and strategic decision-making should be documented as well. Finally, there are situation-specific issues that depend on the type of entity.
Not-for-profit organizations are a focus for the IRS because key employees are often able to increase their own pay. Employees found to be abusing their authority by setting their own compensation at unreasonable levels will have a portion of their pay deemed as an “excess benefit transaction.” These excess payments are subject to a 25 percent excise tax on the amount determined to be unreasonable compensation. Additionally, penalties can be placed on the organization’s management for approving the excess benefits. In order to avoid penalties, boards should base compensation on documented market rates derived from similar positions at peer organizations.
Aside from compensation, loans to officers, directors, donors, and their family members should be discouraged because they could be viewed as disguised compensation. Additionally, rent paid on behalf of officers and travel reimbursements should be properly approved in advance and well-documented to avoid challenges.
C corporations are in danger of overpaying shareholder-employees. Typically, the IRS looks for disguised dividends. Disguised dividends are corporate profits paid out as compensation instead of dividends distributions. Since compensation is a deductible expense, whereas dividend distributions are not, the taxing authorities could consider the excessive compensation as a dividend.
To combat this, companies should develop written compensation plans in advance and note all directors, shareholders, and officers who approved it. Additionally, compensation plans should detail the formula or method for arriving at pay amounts. Bonuses given at year-end are also targets because they might appear to be a distribution of profits. To avoid this, bonuses should be performance-related and the rationale behind the bonus well documented and related to the company’s goals. Also, the board of directors should retain the option of reducing bonus payments to ensure cash is not reduced below the amount needed for working capital and debt service.
Loans from a company to one of its shareholders is another high-risk area for C corporations. Company loans are often determined to be additional compensation or dividends that have been recorded as loans to avoid taxes. Loans should only be made for business reasons and be detailed in a written note secured by collateral and bearing interest at or near market rates.
S corporations are typically audited for underpayment of their shareholder-employees. S corporation shareholders sometimes set their pay low while increasing distributions at the same time to avoid payroll taxes. Fair market pay rates are determined by comparing the shareholder’s pay against others in the same industry in the same or similar position. If the IRS determines the shareholder was being underpaid, it can result in penalties for failure to withhold and deposit taxes. Additionally, the resulting adjustment to increase certain shareholders' pay can create disproportionate distributions. This is an issue because S corporations are generally required to make proportionate distributions based on stock ownership. In a worst-case scenario, these disproportionate distributions could cause the company to lose its S status.
As you can see, almost all types of organizations can face issues related to unreasonable compensation. The best defense against any claims is to pay market rates and document every step of the process.