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Subchapter S Corporations: Reasonable/Unreasonable Compensation

Rex-Vigoren-headshotYou are not only a stockholder but also a corporate officer. Your accountant is questioning whether your officer’s compensation is too high or too low. There are several good ways to evaluate officer’s compensation and to correctly answer the multiple questions contained in your subchapter S corporation tax return.

How does the Internal Revenue Service evaluate whether officer’s compensation is adequate according to the business type? These are some of the considerations all of us need to keep in mind.

  • Make sure you select the correct business activity code. Has the original business activity of the corporation changed since it was incorporated?
  • Does the business conduct more than one type of business?  Which one is primary?
  • Be sure to correctly identify the amount of time devoted by the officer(s) to the business. The Service will use these percentages when comparing current pay levels of the officers to other officers in the same industry.  For the officer/shareholder this time devoted will vary from year to year, especially for those who are involved in multiple entities.
  • What is the stated occupation of the officer?  Is it consistent with the active or passive nature of the business?  Is it consistent with the classification of active or passive on the stockholder’s personal tax return?
  • Do you keep a calendar, date book or equivalent along with documentation to substantiate your level of involvement?
  • Does the corporation show net profit and shareholder distributions with little or no officer compensation?
  • Evaluate officer’s compensation using the multifactor or independent investor criteria.
    • Multifactor
      • Officer’s background – education, training, experience
      • Time devoted to business
      • Comparable compensation in similar businesses
      • Compensation agreements
      • Size and complexity of business
      • Company’s financial performance
      • Prior years compensation
    • Independent investor
      • Consideration of return on investment (or return on equity) expected by a hypothetical investor after officer’s compensation.  Is it comparable to similar businesses?
  • Are there loans on the balance sheet from the company to the stockholder? These may be construed to be disguised distributions especially if they have been outstanding for more than one year.

There are many criteria and methods with which to evaluate whether your activities as a corporate officer and stockholder are being fairly compensated by the S corporation. See your KT advisor to assist with your determination of reasonable officer compensation.

 

Rex Vigoren

Rex Vigoren

CPA, PFS, Partner at Ketel Thorstenson, LLP
Rex joined the firm in 1990 as a Tax Partner and manages the Spearfish office. His experience began with Coopers & Lybrand, grew with the ownership of his own CPA firm and has evolved over 20 years of involvement with Ketel Thorstenson.
Rex Vigoren

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