I have written about “reasonable compensation” rules, as they apply to those small businesses that employ the “S” (that used to mean ‘small’ business) designation. This designation means one is incorporated or has set up an LLC and elected to be taxed as an S entity. (The IRS demands you provide them a signed- by each and every stockholder- Form 2553.)
Given that you have complied with this requirement, you now must pay the working executives (who are stockholders) of the firm a salary that meets certain objectives. Besides the other rules detailed in the post quoted above, there are other rules the IRS considers.
Every entity generates revenue (that’s gross receipts) from some primary sources. These include the services (efforts) of the shareholder(s), the services of non-shareholder employees, royalties (from patents or mineral rights), and from capital and equipment.
Assuming the income comes from the last three items (not from the services of shareholders), then it is likely that such income would be transferrable to the shareholders without requiring “reasonable compensation”. These would be considered distributions or dividends.
But, if (all or part of) the gross revenue derives from the shareholder services, then the “reasonable compensation” rules are in play. And, a significant portion of the revenue that is so derived better come as compensation and not dividends.
The IRS also expects that administrative work be subject to the reasonable compensation rules. (This is one of the reasons why many of our clients employ our services- we effect the administrative work for their entities and obviate the firm from considering reasonable compensation for such services.)
As stated in the post mentioned above, the IRS considers the training and experience of the shareholder/employee, the duties and responsibilities, whether the effort is full or part-time, payments to non-shareholders, as well as what other firms pay for similar services.
Many of our clients argue with the compensation we suggest, when their firms are not generating profits. Because they feel that the firm then has no obligation to pay “reasonable compensation”. After all, the firm is not profitable, and can’t afford their salary. It’s arguable, but the IRS doesn’t see the situation that way.
We suggest to these clients that a salary be paid. (OK, we do more than “suggest”.) Because we know the IRS will impute a higher one that the one we can justify. (It is not in the IRS’ interest to compute a lower salary; if you fail to comply with the law, they pick a number that you have to overrule. That is much harder to do than have them argue with your computations as to what is a reasonable compensation.)
But, each case is different. And, there may be special considerations. Don’t wait until the year is over to come to these determinations. The time is now- before the end of the fiscal year; it insures that you won’t have that knock on the door- or the envelope informing you of your audit.
(Oh, yes. We are available…)
These rules totally baffle me. Some start up companies need every penny they get to go back into the business, but not in salary form.
Suerae Stein recently posted..Picture Perfect Post-its…
Ah, they are not so baffling, Suerae.
But, if a company wants to be able to pass through income to its shareholders, the IRS (and the rest of the government) wants to make sure that the proper taxes are paid.
Unless and until someone wants to pass the (disastrous) laws that now obtain in Kansas (which has decimated their revenue, leaving shortfalls for education, health and welfare, etc.), this rule obtains.
It is pretty obvious that any company that provides services must have the services of an employee. Any firm that sells products in a store must have an employee. Any firm that sells products over the web may (not must) have the need for an employee. Any firm that generates money from capital or equipment (like renting homes/offices/trucks/cars) may (not must) need the services of an employee.
Those are the big differences.
There is no point arguing with the taxman, right? Because he is always right. I am pleased that such a rule doesn’t exist this side of the pond. It makes things more flexible !
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Oh, I don’t know, Muriel. We are often so inclined…