Sound the Alarm – Is Your Compensation Reasonable?

Sound the Alarm – Is Your Compensation Reasonable?

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Developing an appropriate compensation mechanism in private companies for the owners/key employees is and will always present a challenge to the advisors. Unlike non-owners where market forces will force employee wages to an appropriate equilibrium (too low a wage workers will leave; too high a wage workers could be terminated) there is no such mechanism for the employee owners.

Further, the employee owners normally are seeking to reduce their tax burden (within the law of course) and the classification of wages vs profits can yield significant tax savings. Lastly, there will always be debate about what the appropriate salary for a major league shortstop is – when the shortstop is Derek Jeter, the issue gets more complex.

Determining reasonable compensation has always been problematic for businesses. Issues surrounding compensation have been known to result in IRS audits, shareholder lawsuits, and simple disgruntlement among the team. Additionally, reasonable compensation figures usually have an impact on business valuations, shareholder disputes, income taxes and martial litigation.

Employee compensation consists of wages, fringe benefits, bonuses, long and short term incentives, severance pay and stock options. A wide variety of factors are used to develop compensation plans to align the goals of the company and the employee. This includes reviewing the actual duties, time spent on the job, experience level, nature of the organization, ability of the entity to pay, among other factors. Based on the number of factors requiring consideration, it’s very easy to see why determining the right level of compensation for employee owners has ‘art aspects” to it. In fact for the employee owners of a small business, sometimes the form of the payments can dramatically affect how much is kept.

When considering if compensation is reasonable, it’s important to consider some of the red flags which have resulted in further questioning and investigation:

C-Corporation officers taking salaries too high

Compensation of employees and officers is an allowable business deduction. To avoid the double taxation of dividends, it is tempting to distribute the profits in a form of compensation. This results in fewer profits. This in turn decreases corporate taxes, which limits double taxation of the shareholders.

S-Corporations officers taking salaries too low

Officers of S-Corporations may be inclined to take a smaller W-2 compensation and make it up in the form of distributions to avoid paying social security, Medicare, and state unemployment taxes.

Compensation as a percentage of revenue

Analytical analysis can paint a strong picture of an entity. Compensation as a percentage of revenue is computed and compared to the industry standards. If the percentage is significantly higher or lower than expected, further review is often necessary.

Return on Investment appears skewed

Higher compensation results in a low return on investment all things held equal. If the actual return on investment is different than the required rate of return, it’s important to understand why.

In many instances, compensation can be justified based on the operations and history of the entity and industry. It’s important to obtain the necessary support to substantiate compensation paid. We suggest that it be done contemporaneously with the compensation being paid. This can be done through a variety of resources:

Industry Market Data

Market data is compiled by industry to show the historical trends. There are resources specific to analyzing industry compensation data including ERI, RMA, Watson Wayatt and Annual Salary Survey. Many trade associations also provide such data. Salary information is derived by using factors including experience, position, business revenue and location of the entity to help determine compensation reasonableness.

Review the operations and role of the employee in the business

It’s important to take into consideration the role of employees and their responsibilities. If an employee wears “many hats” in the firm it could result in a need for higher compensation. The best source is an interview with the employee and management to understand the duties and the operations of the entity. This in turn can be used to obtain the proper market data.

Review the history of the business

As part of any industry, changes in the economy could affect a business. During economic downturn, it is not uncommon to see decreased salaries and a catch up in the form of a bonus or increased salary given when operations are back on the rise. Therefore, the fluctuation in compensation can be justified based on the review of the entity’s recent history of operations.

The interpretation of what is considered reasonable compensation continues to be debated. It is important to have the proper documentation and data to support the compensation figures before it is being questioned. Without the proper support, it potentially sounds the alarm for additional questioning and concerns.

Melissa Soranno, CPA Melissa Soranno, CPA
609-520-1188
[email protected]

Melissa Soranno, CPA

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The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.

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