From the September 2000 issue of Entrepreneur

When the profits are flowing in, it's often tempting to give yourself a nice, big bonus at the end of the quarter. But you'd better keep your greed at bay if you're organized as a regular corporation: The IRS is going after those business owners who pay themselves too much.

A number of entrepreneurs have ended up in court on the issue, and the IRS has come away with some impressive wins. It has successfully argued that a portion of the compensation taken, including bonuses, should have been declared corporate dividends. When dividends are declared, the owner is taxed twice on the income, once at the corporate level and again when the owner receives the money.

As you know, compensation is considered a business expense and deductible. To be deductible, however, the IRS maintains that those salaries and wages must be ordinary and necessary, as well as reasonable. Red flags often go up, say tax experts, when the IRS sees profits increasing and the owner spiking his or her own salary and bonus excessively.

To decide whether compensation is reasonable, the IRS looks at a number of factors. These include the nature and size of the business, the nature and scope of the work the owner does at the company, the amount of time required for the services, and any special qualifications the owner has. Industry surveys and third-party studies help determine what is considered reasonable compensation for companies in the industry.

Chalk One Up for the IRS

Because the agency has enjoyed a good deal of success in court on this, taxpayers need to be wary, says Thomas P. Ochsenschlager, a partner in accounting firm Grant Thornton LLP's Tysons Corner, Virginia, office. "If the IRS audits your company and sees anything that looks like excessive compensation, not only will it push hard on the audit, but the agency won't compromise with you," he explains. "It will take you to court because it has been very successful in that venue."

Some business owners often "push the envelope in this area," says Mark Luscombe, principal federal tax analyst for CCH Inc., a Riverwoods, Illinois-based provider of tax and business law information. "The IRS is looking to see whether there is a pattern on a return of low tax and a salary level that fluctuates up and down with the income earned. That's often a tip-off that maybe there's some funny business going on with setting compensation," he explains.

A few recent cases offer several useful insights.Take the case of Olympic Screen Crafts (OSC) & Associates Inc. v. the IRS Commissioner. Owner Allen Blazick opened up this shirt silk-screening company in 1970 for $180. When the business began to grow, Blazick brought in his brother-in-law, Steven Richter. In 1982, Blazick decided to incorporate. He became president and CEO and owned 90 percent of the company. Richter was then named vice president and owned the remaining 10 percent.

By 1991, the company had more than 200 employees and annual gross sales of more than $13 million. Three years after incorporating, Blazick and Richter adopted an incentive compensation plan that was intended to recognize the two for their contributions to the company. The plan stated that payment would be made according to the stock ownership of the two owners.

The two owners were the plan's only participants. Under the formula established by their accountant, nearly all of the company's net income was distributed as incentive payouts to the two owners and deducted as compensation. The business never declared or paid out any dividends.

OSC offers a textbook case of what not to do regarding compensation, says Ochsenschlager. The court found that if the bulk of the corporate earnings are paid out as bonuses, as OSC's were, it's fairly clear that profits are being siphoned out of the company disguised as compensation. Another questionable practice cited by the court was the fact that the company never paid or declared a dividend, even though in 1988 or 1989 the company's accountant advised OSC to pay them. The IRS even presented a credit memorandum prepared by Blazick's bank saying that Blazick had indicated he "does not intend to be taxed twice for the profitability of his business."

The IRS won this one hands down. As a result, the tax agency disallowed a substantial amount of the compensation, saying it represented nondeductible "disguised dividends." The tax court agreed with the finding, as did the U.S. Court of Appeals. In addition to instructing the owners to pay the taxes owed, the company was assessed a penalty for negligence.

In another case, the IRS successfully found that a good portion of the compensation independent contractor Kirk Eberl claimed in 1992 and 1993 also constituted "disguised dividends." Eberl was an independent claims adjuster helping insurance agencies settle claims in areas hit by disasters. In his case, Eberl was being paid a negotiated fee for each claim he handled. In 1992, he took compensation totaling $4.3 million and in 1993 his compensation was just over $2 million.

The court found that Eberl set his own compensation. In addition, he distributed almost all the profits to himself at the end of the year. Therefore, says the court, a substantial portion of his compensation was "a disguised dividend." It ruled that Eberl could take only $2.3 million in 1992 as reasonable compensation and $1 million in 1993. In addition to the payment of additional taxes, he was also hit with a hefty penalty for the two years in question.

Avoidance Strategies

While those two cases resulted in unpleasant outcomes for the business owners, tax experts say there are ways to avoid such difficulties. One way is to organize your business as an S corporation. As you know, with an S corporation, profits are taxed only once at the shareholder level (whether or not distributed). With an S corporation, "generally there is no tax at the corporate level," says Ochsenschlager.

Yet another step is to get your company's compensation plan put into place at the very beginning of the year, says Luscombe. The IRS becomes suspicious whenever it sees that compensation is determined at the end of the year after profits are already known. At that point, it appears to the IRS that bonuses are being given in an attempt to zero out the profits. If the plan is put into place at the beginning of the year, including the bonus program, it looks much more like it's a "bona fide compensation plan," Luscombe says.

Ochsenschlager agrees and strongly suggests businesses have an independent board of directors who decide on the details of any compensation plan. "The shareholder-employees shouldn't get together on the plan," he advises.

Setting up an independent board can be difficult for some smaller companies, says Luscombe, because they don't like to get outsiders involved on the board. Even so, personal acquaintances are often willing to serve, says Ochsenschlager, and the IRS has a tough time challenging an independent board, even if it's made up of friends.

A lot of publicly held companies set up such boards and often have compensation committees devise the various levels of compensation. However, a lot of shareholder groups are very critical of executive compensation committees because the members are almost always hired by the owners and don't appear to be in any way neutral. If a compensation committee simply isn't feasible, Luscombe says, have the general board of directors be the ones to approve the plan.

It's also strongly advised that you avoid having your compensation appear in any way proportional to stock ownership. If it is, it's often a dead giveaway, he says, that the compensation is actually a disguised dividend. The owners of OSC & Associates were guilty of exactly that and, as a result, raised the interest of the IRS.

Another important step to take is to add a statement to your corporate minutes indicating your intentions about future compensation payments when the company's profits increase. If you plan to reward certain individuals who have been underpaid in the past, be sure to include this fact somewhere within the minutes, says Ochsenschlager.

Because of its success in this area, the IRS is in a strong position when it comes to excess compensation. Therefore, say tax experts, take the necessary steps now to make sure that you keep the IRS at bay. It could keep you out of what is sure to be a very painful briar patch.


Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.