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  • Preventing a Challenge to (Un)Reasonable Compensation
    © 2013 American Institute of CPAs - All Rights Reserved. Reprinted with permission from the September 2013 issue of Journal of Accountancy. ►  IRS scrutiny of excessive executive compensation is increasing, affecting many types of taxpayers.  CPAs need to advise their clients on steps they can take to lessen their exposure in this area. By Stephen D. Kirkland, CPA, CMC, CFF As a result of IRS training initiatives, three types of entities draw the most attention and therefore need good advice from CPAs. First, closely held C corporations are examined to determine whether they have overpaid their shareholder-employees. These corporations are allowed to deduct only “reasonable” compensation paid to shareholder-employees. So, examiners are looking for a disguised dividend, which is corporate profit being treated as compensation. Since a dividend is not deductible, but compensation is, the IRS may treat the portion of the compensation that it considers excessive as a dividend. The result is that the corporation loses its deduction for that amount and is assessed tax, interest, and penalties on the deficiency. Conversely, S…
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  • What is Excessive Compensation?
    Excessive compensation is the portion of cash and benefits that, in total, exceeds the value of services provided in exchange for that compensation. To make this determination, the value of all services provided are considered. For executives, such services commonly involve roles in management, marketing, operations, finance, and human resources. They may also include special services such as providing a personal guarantee of company debts.
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  • How does the IRS define Reasonable Compensation?
    Internal Revenue Code section 162(a)(1) allows income tax deductions for various business expenses, including “a reasonable allowance for salaries or other compensation for personal services actually rendered.”  Reg. section 1.162-7 (b)(3) says, “It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.”
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  • How is Reasonable Compensation Determined?
    There are multiple methods of determining reasonable compensation amounts. The oldest approach is known as the multi-factor method, and it considers all the facts and circumstances. One of the key facts is referred to as compensation comparability data. This data should be actual amounts that similar employers paid for similar services. The independent investor test focuses on the profitability, or return, available to the company’s owners after the compensation has been paid. If the investors' return is satisfactory, it may be presumed that the executives did not receive excessive compensation.
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