Page 68 - BCM May 2024

ACCOUNTING

Compensating the Boss

Paying too much… or too little… can attract the attention of the IRS.

he IRS has long demanded that the owners and key or an employee a below-market loan must, depending on
T employees of a business be compensated fairly. at the circumstances, treat the repayment as a gift, a dividend,
means they’re on the lookout for compensation that is not distribution of capital, payment of wages or other payment.
“reasonable.” A business paying the owner a relatively small Also, like other payments, it must be reasonable.
amount may be attempting to reduce the operation’s payroll Generally, the owner/employee of a pro table bowling
tax burden. Excessively rewarding an indi- center should receive both wages and dividends. Dividends
vidual could result in shifting income that — whether cash, stock or other assets — are not taxed if they
would be taxed in a lower bracket. are a return of capital.
To be considered reasonable by the ever- Typically, the owners of closely held, incorporated bowl-
vigilant tax collection agency, the amount ing centers can avoid double-taxation if the business pays
paid for the performance of services must most of its pro ts in the form of a bonus or by leaving pro ts
be equivalent to what a similar business in the business as accumulated earnings. e IRS can have
MARK E. would pay to someone performing similar a eld day re-characterizing bonuses as a non-deductible
BATTERSBY services. In other words, reasonableness dividend.

is determined based on all the facts and e failure of an incorporated center to make non-deduct-
circumstances. ible payments of su cient dividends relative to pro ts can
e role of the individual, either the owner or employee, subject it to the accumulated earnings tax.
in the bowling center and those paid by similar businesses A business owner can also opt for an owner’s draw. Un-
for similar services are all factored into the decision, along like W-2 wages, a draw is not taxed at the company level. A
with the character and condition of the center. sole proprietor or partner’s income is a draw although an
e most glaring potential trap is largely limited to pub- owner’s draw can be made from an LLC or even an S corpo-
licly traded companies that are barred from deducting any ration.
applicable employee renumeration more than $1 million When it comes to determining the reasonableness of any-
annually. e Tax Cuts and one’s salary, the IRS has failed
Jobs Act (TCJA) expanded the to provide business owners
scope of “publicly held corpo- and shareholder/employees
rations” to include all for-pro t A lack of specifi c IRS guidance has with speci c guidance. is
businesses required to le left many business owners and their has left many small-business
reports with the Securities and tax advisors resorting to various owners — and their tax advi-
Exchange Commission. sors — resorting to various
An o cer in an incorporated rules of thumb rather than basing rules of thumb rather than
bowling center is generally their fi gures on empirical data. basing their gures on empiri-
an employee. An o cer who cal data.
performs no services or only Not surprisingly, the courts
minor services and who nei- are often asked to determine
ther receives nor is entitled to receive any pay is not consid- what is “reasonable.” According to many experts, the fac-
ered an employee. tors the court weighs include compensation of nonowner
Any distribution to shareholders from earnings and pro ts employees, past salary history, industry formulas and the
is generally labeled as a dividend. A dividend is not, how- nancial condition of the business.
ever, a taxable distribution if it is a return of capital to the However, even though all these factors are considered, the
shareholder. Most distributions are in money, although they court’s most heavily weighted consideration appears to be
may also be in stock or other property. summarized as the replacement cost to the company of hir-
A loan by a corporation to a corporate o cer should ing an outside party to perform the business owners’ duties.
clearly be a loan, made at arm’s length. ere should be a In order to both pro t from and avoid the potential pitfalls
contract with a stated interest rate, a speci c length of time of reasonable compensation, early planning is essential
for repayment and a consequence for failure to repay. A before an audit results in headaches and expensive penal-
below-market loan is a loan that provides no interest or an ties. Seeking professional guidance for reaping those tax
interest rate below the federal rate. breaks can ensure that you don’t run afoul of the tax laws in
An incorporated bowling center that gives a shareholder this area.

66 • BCM • MAY 2024 www.bcmmag.com

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