IRS May Question Salaries for Owners of Small Firms / Income May Be Subject to Double Taxation; Results All around Can Be Financial Murder

Article excerpt

If you are the owner of a small, private company that pays you a salary, is that payment ``reasonable''?

You may think so and the general public with which you do business may not question the payment - but if the Internal Revenue Service starts poking around, it may not agree. If it doesn't, look out!

If your salary is held to be unreasonably high by the IRS, its deduction from corporate taxable income may be disallowed and thus the income may be subject to double taxation. What's more, if corporation contributions to a retirement plan are based on compensation, you may lose that deduction as well. The results all around can be financial murder.

To illustrate, consider the recent case of a struggling closely held company that paid its president a salary equal to a percentage of the company's profits. Over the years, the company's profits grew and the president's salary reached more than $300,000 per year. The IRS held the salary to be unreasonable.

When the tax court agreed, the taxpayer appealed. The court of appeals later found the salary to be reasonable, citing that it was set under an arm's-length contract and was fair when made. Furthermore, it pointed out that the IRS had not challenged the agreement when the company was struggling, but only when profits increased.

In another case, the owner of a vineyard paid himself $181,000 in salary one year and $120,000 the next. The IRS, however, ruled that all salary over $40,000 a year was excessive and therefore non-deductible. The ruling was challenged with the owner arguing he was worth his pay, working 70- to 80-hour weeks. The tax court partially agreed, raising the reasonable compensation ceiling to $75,000 for each of the two years.

Many owners of privately held businesses fail to consider federal rules on the amount of pay they can receive. All reasonable compensation is deductible -- but any amount the IRS deems ``unreasonable'' is not. If this happens, you are in deep trouble.

When challenging compensation, the IRS will attempt to show that the owners are avoiding double taxation by disguising their dividend income as compensation income. …