The IRS requires that compensation must be reasonable for the personal services actually rendered by a shareholder-employee. This reasonable compensation standard can be applied to adjust compensation that is either too high or too low.
There is no rigid set of rules for measuring the reasonableness of compensation. No definition of “reasonable” is contained in the Code; the regulations provide only that reasonable compensation is an amount paid for like service by like enterprise under like circumstances. Court cases have shown, however, that each situation must be resolved based on its unique facts and circumstances. Some Tax Court decisions have focused on the following five factors:
1. the character and financial condition of the corporation;
2. the role the shareholder plays in the corporation, including the employee’s position, hours worked, and duties performed;
3. the corporation’s compensation policy for all employees and the shareholder’s individual salary history including the corporation’s internal consistency in establishing the shareholder’s salary;
4. how the compensation compares with similarly situated employees of similar companies; and
5. whether a hypothetical independent investor would conclude that there is an adequate return on investment after considering the shareholder’s compensation.
In these and other cases, the courts have also considered additional factors in deciding whether the amount of compensation is reasonable, including:
1. the employee’s qualifications;
2. the size and complexity of the business;
3. a comparison of salaries paid to sales and net income;
4. general economic conditions;
5. comparison of salaries to shareholder distributions and retained earnings;
6. compensation paid in prior years;
7. the corporation’s dividend history;
8. whether the employee and employer dealt at arms’ length; and
9. whether the employee guaranteed the employer’s debt.
The court decisions confirm that no single factor controls, but rather a combination of the factors must be considered. Furthermore, these factors are not all-inclusive (and may not be given equal weight). Fewer or additional factors may be appropriate, depending on the surrounding facts and circumstances.