IRS Reasonable Executive Compensation

Constructive Distributions

If a corporation pays a shareholder-employee a salary that's unreasonably high considering the services actually performed, the IRS may treat the excessive part of the salary as a constructive distribution of earnings to the shareholder-employee, also referred to as a constructive dividend.

What does this mean? If there is a constructive distribution, the employee-shareholder's wages are reduced, and the difference is treated as a dividend. This creates increased corporate taxable income and tax liability for the corporation since the reduced wages increase the corporation's earnings by the amount of the dividend. The constructive distribution would result in penalties and interest to be paid on the underpayment of taxes unless the corporation makes adjustments.

To avoid the penalties, the corporation and shareholder-employee can enter into a Compensation Reimbursement Agreement.

There's a legal obligation to return the funds, so the shareholder-employee is not allowed an IRS Section 162 deduction for the repayment. In addition, the amount that's disallowed as unreasonable compensation cannot be re-characterized by the corporation and deducted as another business expense.

Q:What happens if the compensation isn't returned?

A:Then the individual continues to have taxable income in the form of dividends. But reduction of paid compensation will decrease the amount the employee can contribute to deferred compensation plans.

If the corporation chooses to challenge the re-characterization of the compensation, then the burden of proof is on the taxpayer/corporation.

The presumption is that the determination of the IRS is correct. The taxpayer must rebut this presumption with acceptable, credible testimony or other evidence, and show the merits of the claim by at least a preponderance of the evidence.