Reasonable Compensation of Shareholders and Officers

A deduction is allowed for compensation, but the amount must be reasonable and the payment must be solely for services. (IRC §162(a); Treas. Regs. §1.162-7(a)) The Ninth Circuit uses five factors to determine the reasonableness of compensation:

1. The employee’s role in the company
2. Comparison of compensation paid by similar companies for similar services
3. The character and condition of the company
4. Potential conflicts of interest; and
5. Internal consistency of compensation arrangements

Both C corporations and S corporations might be tempted to pay unreasonable compensation, but they are the flip sides of each other. C corporations might be tempted to pay unreasonably high compensation to their shareholder-employees to avoid paying nondeductible dividends. On the other hand, S corporations might be tempted to use unreasonably low compensation to avoid employment taxes.

In the case of S corporations, the IRS lists the following factors in determining the amount of reasonable compensation:

1. Training and experience
2. Duties and responsibilities
3. Time and effort devoted to the business
4. Dividend history;
5. Compensation to non-shareholder employees
6. Timing and manner of paying bonuses to key employees
7. What comparable businesses pay for similar services
8. Compensation agreements; and