Is Your Compensation Reasonable Or A Disguised Dividend?

Are you an employee of your own California corporation? How much are you paying yourself as salary? How much are you paying yourself as a year-end bonus? Are you unwittingly creating a tax problem for yourself?

An employer, including a California employer, is not entitled to deduct certain compensation paid if that compensation was not reasonable in amount. The excess monies paid are a disguised dividend which causes a tax problem for the employer who will have to pay tax on the amount deducted deduction that will be disallowed by the IRS.

Internal Revenue Code Section 162(a)(1) permits a corporation to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The test for deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.

A deduction for compensation that is, in fact, reasonable is an amount “as would ordinarily be paid for like services by like enterprises under like circumstances.”

The 9 Factor Test of Reasonableness

The reasonableness inquiry is governed by the nine – factor test based on a case called Owensby & Kritikos, Inc. v. Cmm’r., 819 F.2d 1315, 1323-24 (5th Cir. 1987).

These nine factors are:

1. The employee’s qualifications;

2. The nature, extent and scope of the employee’s work;

3. The size and complexities of the business;

4. A comparison of salaries paid with gross income and net income;

5. The prevailing general economic conditions;

6. Comparison of salaries with distributions to stockholders;

7. The prevailing rates of compensation for comparable positions in comparable concerns;

8. The salary policy of the taxpayer as to all employees; and
9. Compensation paid in prior years.

Courts will examine and weigh the totality of the facts and circumstances in determining reasonable compensation so that no one factor will be determinative of reasonableness.

The IRS’s determination of reasonableness is presumptively correct which shifts the burden to the taxpayer to establish that he is entitled to a deduction larger than that allowed by the Service.

If you have been challenged by the IRS about your compensation deduction and would like to consult with a tax attorney, call Mitchell A. Port at (310) 559.5259.