Looking to Benchmark Pay?
SUMMARY
This course primarily reviews the application of the IRS definition of reasonable compensation to the compensation of stockholder-employees in closely held corporations. In the eyes of the IRS, stockholder-employees tend to either underpay or overpay themselves depending on the type of incorporation.
The course examines these different forms of ownership in for-profit enterprises:
- proprietorship
- partnership
- limited liability company (LLC)
- S corporation
- C corporation
In the simplified example developed for this course, the principals would pay the MOST taxes in a partnership. This would be somewhat alleviated by their being able to deduct 50% of their self-employment tax from their adjusted gross income. They'd pay the LEAST taxes in a C corporation, assuming they only take a salary (possibly with bonus), but no dividends.
Maximum Reasonable Compensation
Taking a bonus out to reduce earnings to zero, seems to be the best way to get profits out of the C corporation and reduce taxes, but this alternative could put you at odds with the requirement for maximum reasonable compensation. There's no single way to measure maximum reasonable compensation. Tax courts traditionally use a combination of factors covering competitive wages, performance (personal and corporate), contribution, company policies, and financial conditions.
Research Software
ERI (in conjunction with the IRS) has developed a measure of maximum reasonable compensation that has a 2.0 standard error. The standard error represents the range of pay in which you might find 95% of the population. Where compensation is deemed to be excessive, the excess is reclassified as a constructive dividend with appropriate taxes, penalties, and interest charged.
Independent Investor Test
A different approach, the independent investor test, considers the return on investment indicated by the increase in the value of the corporation's stock along with dividends paid during the time period. The independent investor test has been used by one court of appeals as a sole criterion. Other appeals courts have begun to use it in addition to other factors. TSR is a prevalent measure used for this purpose by publicly traded companies.
Business Valuations
Lastly, this course shows how altering stockholder-employee compensation can provide very different values to a corporation depending on how the information is to be used. When gifting stock, the shareholder-employee would prefer the lowest valuation for the company, so compensation should be high. When selling a business, the company's highest value is, of course, preferable, so shareholder-employee compensation should be low.