Stephen Kirkland's 2018 and 2017 Presentations

“Mastering the Rules of S Corporation Shareholder-Employee Compensation”
Strafford Webinar, January 31, 2018

“Normalizing Owner Compensation in Business Valuations”
National Association of Certified Valuators and Analysts (NACVA), Webinar, December 18, 2017

“Getting Paid What Your Services are Worth”
Financial Valuation SuperConference, San Diego, December 12, 2017

“Normalizing Owner Compensation: Up Your Analysis”
Business Valuation Resources (BVR), Webinar, December 5, 2017

“Normalizing Owner Compensation”
American Society of Appraisers (ASA) Advanced Business Valuation Conference, Houston,  October 8, 2017

“Getting Paid What Your Services are Worth”
NACVA, Webinar, September 18, 2017

“Getting Paid What Your Services are Worth”
NACVA, Webinar, July 26, 2017

“Getting Paid What Your Services are Worth”
NACVA’s Annual Consultants Conference, Chicago, June 9, 2017


Reasonable versus Unreasonable Compensation

The topic of reasonable compensation versus unreasonable compensation is one of the hottest issues in American business today.  The Securities and Exchange Commission is requiring more disclosure of executive compensation details at publicly-traded corporations.  Shareholders are protesting some CEO compensation packages.  Internal Revenue Service and state auditors are looking for over-compensated shareholders at closely-held C corporations and under-compensated shareholders at S corporations.  The IRS announced that they had imposed $21 million in excise taxes on forty officers and board members at charitable organizations due to “excess benefit transactions” in the form of unreasonable compensation.  High-profile class action lawsuits have been filed against large employers who may have permitted investment managers to receive unreasonable compensation for services they provided to retirement plans.  Also, an accounting rule known as FIN 48 requires that financial statements include a provision for potential tax liabilities which could arise due to uncertain tax positions taken by the company, such as the payment of potentially unreasonable compensation.  At privately-owned companies, shareholder disputes over compensation have become common.  In marital dissolution cases, one of the most litigious issues is the amount of compensation one spouse receives from a closely-held business.

In addition, the national media is debating whether executives are really worth the amounts they are taking home.  And, since the answer to that question has dramatic tax consequences, the Internal Revenue Service (IRS) is paying close attention to this debate.

Pursuant to Internal Revenue Code section 162, the IRS allows corporations to deduct “ordinary and necessary” expenses incurred in carrying on their businesses.  This includes compensation for services performed by stockholders and their family members, but only if the amounts paid are “reasonable” for the services performed.

C corporations pay income tax on their earnings and then may distribute some of the after-tax earnings to shareholders as non-deductible dividends.  The shareholders must pay income tax on the dividends they receive, so corporate earnings are taxed twice, once at the corporate level and once at the shareholder level. However, compensation is taxed only once – to the employee.

A closely-held C corporation paying excessive compensation to a shareholder-employee is required to treat the excess portion as a dividend (provided there are adequate earnings and profits).

Regardless of why compensation amounts are being evaluated, many facts and circumstances are considered.  The analysis can be complex and requires judgment.  But compensation may be considered reasonable if a similar amount was paid for comparable services provided by another employee who was not a stockholder.  An exact match, however, is rarely available.  We may also look to see how much was paid by peer companies for similar services.  Compensation databases can sometimes be used to determine amounts (or ranges) paid by similar-sized companies in the same industry for comparable services.  Completing these steps, however, is not as easy as it sounds.  For example, in today's climate, many businesses do not fit neatly into any one industry.

We may also consider how much an employee would be paid if the business was owned by an unrelated investor.  After payment of all compensation, are there enough earnings left in the company to satisfy this hypothetical investor?  If so, that may be one factor which suggests that the compensation was reasonable.

To determine a reasonable level of pay for an employee, we consider many additional factors.  For example, look at the employee’s input – long hours, special skills, relationships, years of experience and education brought to the job.

We also look at the employee’s output, or the results he or she achieved.  After all, pay for key employees should be performance-based.  Consider new clients and contracts brought to the company, increases in profitability, and similar accomplishments.  Measuring one person’s accomplishments can be difficult and time-consuming, however, since most accomplishments come from the efforts of multiple people working together.

Also consider the size of the company, the complexity of the industry, economic conditions, the geographic location and other factors.

An executive’s compensation for a particular year may include an amount for services he or she performed in an earlier year.  Business owners may receive little or no pay in the early years of a business, even though that may be when they work the hardest.  They also may not be adequately paid during periods of rapid growth, when cash flow is tight.  If so, they may be entitled to catch-up pay later.  If an employee will be underpaid until a new business becomes profitable, and will receive proportionately larger pay later, consider stating that in board minutes or an employment agreement.

In addition to an employee's salary, employer-provided benefits may be considered in determining whether an employee's compensation is reasonable.  This could include pension and welfare benefits, as well as fringe benefits such as personal use of a company car.  An otherwise high salary might be reasonable if the employee’s benefits are less than those usually provided to a comparable employee.

Due to the potentially adverse tax consequences, some shareholder-employees document the reasonableness of their compensation and explain how the amounts were determined.  Documentation may describe the unique and valuable nature of their skills and the services provided.

If a year-end bonus is to be awarded, consider putting the terms in writing in advance.  There are many ways to design a bonus plan to provide incentives.  A bonus may be equal to some percentage of the increase in pretax profits over the prior year, for example.  If awarded, a resolution may be used to explain how and when the bonus was earned and computed.  However, for better or worse, many closely-held businesses are managed informally without such documentation.

The Internal Revenue Code  

Code § 162(a) reads:

“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including - - a reasonable allowance for salaries or other compensation for personal services actually rendered . . .”

The Regulations   (Emphasis added.)

The Regulations under Code § 162(a)(1) provide guidance in interpreting the statute.

Treas. Reg. § 1.162-7 Compensation for Personal Services.

a.            “There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered.  The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.

b.            “The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows:

(1)          Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible.  An ostensible salary paid by a corporation may be a distribution of a dividend on stock.  This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries.  If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.  An ostensible salary may be in part payment for property.

(2)          “The form or method of fixing compensation is not decisive as to deductibility.  While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate.  Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid. 

(3)          “In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances.  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.

Treas. Reg. § 1.162-8     Treatment of Excessive Compensation.

“The income tax liability of the recipient in respect of an amount ostensibly paid to him as compensation, but not allowed to be deducted as such by the payer, will depend upon the circumstances of each case.  Thus, in the case of excessive payments by corporations, if such payments correspond or bear a close relationship to stockholdings, and are found to be a distribution of earnings or profits, the excessive payments will be treated as a dividend.  If such payments constitute payment for property, they should be treated by the payer as a capital expenditure and by the recipient as part of the purchase price.  In the absence of evidence to justify other treatment, excessive payments for salaries or other compensation for personal services will be included in gross income of the recipient.”

Treas. Reg. § 1.162-9     Bonuses to Employees.

“Bonuses to employees will constitute allowable deductions from gross income when such payments are made in good faith and as additional compensation for the services actually rendered by the employees, provided such payments, when added to the stipulated salaries, do not exceed a reasonable compensation for the services rendered.  It is immaterial whether such bonuses are paid in cash or in kind or partly in cash and partly in kind.  Donations made to employees and others, which do not have in them the element of compensation or which are in excess of reasonable compensation for services, are not deductible from gross income.”

In addition, employer-provided benefits are considered in determining whether compensation is reasonable.  This includes pension and welfare plans, as well as fringe benefits such as the use of a company car.  An otherwise high salary might be reasonable if the employee’s benefits are less than those typically provided to a comparable employee.

If a year-end bonus is to be awarded, the amount should be determined carefully.  The bonus may be set as some percentage of the increase in pretax profits over the prior year, for example.  If a bonus is awarded, a resolution could be used to help explain how and when it was earned.

An executive's compensation for a particular year may include an amount for services performed in an earlier year.  Business owners often receive reduced pay in the early years of a business, even though that may be when they work the hardest.  They also may not be adequately paid during periods of rapid growth, when cash flow is tight.  They are entitled to catch-up pay later.  If the employee will be temporarily underpaid, and will expect catch-up pay later, consider saying so in a written employment agreement, but be sure to consult with legal counsel.

Due to the potential adverse tax consequences, shareholder-employees should carefully document the reasonableness of their total compensation, explain how the amounts were determined, and document the unique and valuable nature of their services.

S Corporations

Unlike owners of C corporations, S corporation shareholders are tempted to keep their compensation low.  This is because compensation paid to S corporation shareholders is subject to payroll taxes but profit distributions are not.  Therefore, to minimize payroll taxes, S corporations may decrease shareholder compensation and increase profit distributions.  In response, federal and state tax authorities regularly audit S corporations to ensure they pay enough compensation.  As with C corporations, documentation should be kept to show how compensation levels were set.

Tax-Exempt Organizations

The Internal Revenue Service is now closely examining compensation levels paid by non-profit organizations to their key employees.  Under Internal Revenue Code section 4958, the IRS can impose a 25% excise tax on over-paid employees (or independent contractors) and a 10% excise tax on the organization's managers who permitted unreasonable amounts to be paid.  For information on avoiding the section 4958 excise taxes, please visit

These compensation issues are often raised in IRS audits.  To keep your guard up, pay for performance and maintain good records.


Stephen Kirkland, CPA, CMC, CFC, CFF is a compensation and tax consultant and serves as an expert witness in U.S. Tax Court and other cases involving compensation issues.

Our income tax laws are complex and change often.  Please work closely with a tax advisor in structuring compensation plans to avoid costly mistakes.

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Stephen Kirkland can be reached at (803) 724-1414.