Would Your Company Pass the Independent Investor Test?

The IRS is planning to crack down on tax evasion to help fund the Biden administration’s ambitious economic agenda. Specifically, the White House hopes to generate approximately $700 billion in tax revenue over the next decade by expanding the IRS’s enforcement authority and increasing its funding by $80 billion. If Congress approves the increased funding, the IRS plans to hire more auditors and invest in updated audit tools and technology.

Enforcement efforts will focus on high-net-worth taxpayers and corporations. So, one area that the IRS will likely target is deductions for owners’ compensation. Here are the factors the IRS considers when evaluating compensation levels, which business owners can use to support their tax deductions — in case the IRS comes to call.

The Basics

Internal Revenue Code Section 162(a) permits deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” To be deductible as an expense of a trade or business, compensation payments generally must be:

• Ordinary and necessary,
• An expense of the trade or business during the taxable year,
• Reasonable in amount, and
• For personal services rendered.

If compensation is paid partly for business purposes and partly for nonbusiness or personal purposes, only the compensation applicable to the business purposes is deductible.

What’s Reasonable?

“Reasonableness” is a subjective standard that varies depending on the facts of the taxpayer’s situation. The U.S. Tax Court considers the following five factors to determine whether an individual’s compensation is reasonable:

1. Role in the company. This factor focuses on the employee’s importance to the success of the business. Courts will consider his or her position, duties performed and hours worked.

2. External comparison. This factor compares the employee’s compensation to what similar companies pay unrelated parties for performing similar services. If relevant comparables are available, the Tax Court typically gives this factor significant weight.

Common sources of compensation data include salary surveys published by trade groups or industry analysts, as well as proxy statements and annual reports of public companies. Private company compensation reports, such as data published by Willis Towers Watson, Dun & Bradstreet or the Economic Research Institute (ERI), are also available to support compensation deductions.

If a particular employee is paid more than other similarly situated employees of the company, the business should document why the individual deserves a higher level of compensation.

3. Character and condition of the company. This factor focuses on size (as measured by revenue, net income or capital value), complexities of the business and general economic conditions.

Important: In today’s tight labor market, companies may need to increase the amount paid for certain positions or in certain geographic areas where there’s a short supply of qualified workers.

4. Internal consistency of compensation. This factor focuses on whether the compensation was paid pursuant to a structured, formal and consistently applied program. Subjective or erratic bonus payments or payments that violate company policy may be suspect.

5. Conflicts of interest. This factor considers whether a relationship exists between the business and the employee that may permit the company to disguise nondeductible corporate distributions as deductible compensation. Such a relationship may exist when an employee is the company’s controlling shareholder or a member of the controlling shareholder’s family. This is where the independent investor test comes into play.

Eye on Investor Returns

The focus of the independent investor test is essentially whether a hypothetical investor would receive a reasonable return on equity (ROE) after payment of the compensation. If the company’s ROE would satisfy an independent investor, there’s a strong indication that the employee’s compensation is reasonable and the payments aren’t disguised distributions.

When applying the independent investor test in previous cases, the Tax Court has ruled that a return of at least 10% tends to indicate that an independent investor would be satisfied. Moreover, the court generally has held that compensation payments that leave a rate of return of at least 10% for hypothetical investors are reasonable. However, this rule of thumb may vary, depending on the taxpayer’s situation.

IRS Targets: C Corporations vs. S Corporations

The IRS is on the lookout for C corporations that pay employee/shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid because salaries are a tax-deductible expense and dividends aren’t.

Owners pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of the owners’ salaries as dividends.

For S corporations and other pass-through entities (such as partnerships, limited liability companies and sole proprietorships), the IRS looks for businesses that underpayowners’ salaries to minimize state and federal payroll taxes. Rather than pay salaries, S corporations are more likely to pay distributions to owners because they’re generally tax-free to the extent that the owner has a positive tax basis in the company.

Need Help?

Reasonable compensation is more than a tax matter. Similar issues can arise in other cases, too. For example, it may be a point of contention in shareholder disputes and divorce cases. If you’re faced with questions regarding what level of compensation is reasonable — in a tax situation or for other purposes — contact a financial professional. He or she can provide an objective analysis of the case at hand.

We can help you tackle business challenges like these – schedule an appointment today.

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