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1992-10-01
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@043 CHAP 8
┌─────────────────────────────────────────┐
│ "UNREASONABLE" COMPENSATION PROBLEMS │
└─────────────────────────────────────────┘
"Behind every great fortune there is a crime."
-- Honore de Balzac
Some closely-held C corporations try to escape from being
caught between a rock and a hard place (between double tax-
ation if dividends are paid, and accumulated earnings or
personal holding company penalty tax if income is accumu-
lated in the corporation) by raising the compensation paid
to the employee-owners (or their relatives on the payroll)
to levels high enough to zero out the corporate income.
This works beautifully until the IRS audits the corporation
and decides that the compensation paid is unreasonably
high, and disallows part of it. In that case, unless one
can convince the IRS (or a court) otherwise, the excess
compensation is treated as a constructive dividend and is
still fully taxable to the recipient, but not deductible to
the corporation. This can also have other disastrous side
effects, such as disqualifying a pension or profit sharing
plan, where the contributions to the plan by the corpora-
tion were based on the "unreasonable" compensation, rather
than the lesser amount the IRS allows as a compensation
deduction.
S corporations generally do not have to worry about "un-
reasonable compensation," although if compensation paid is
too low, the IRS may impute a higher level of salary ex-
pense, which reduces an S corporation's net income, and is
thus a wash, overall. The IRS will sometimes make such an
adjustment in the case of an S corporation where a parent
who runs a business has given stock to his or her children
and takes out little or no salary so that the corporation
will have more taxable income to be split with the children.
Or the IRS may argue that compensation is too low where an
employee-owner of an S corporation takes little or no sal-
ary in order to avoid FICA and unemployment taxes. (There
will be no such payroll taxes if he or she takes all of the
S corporation's income out in the form of dividends, rather
than compensation.)
A similar re-allocation of partnership income can occur in
a "family partnership" where there is an attempt to allo-
cate partnership income to children who have not earned it.
Sole proprietors don't have to worry about "unreasonable
compensation" unless making payments of salary or wages to
family members who do not earn the compensation.