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.