It’s not uncommon at year-end for manufacturing company owners to review the year’s performance and consider whether they’ve been fairly compensated for their efforts. Indeed, if the business has extra cash on hand, owners may decide to pay themselves a holiday bonus or make a special distribution to help cover their personal tax obligations for earnings from a pass-through business.
However, the amount of an owner’s compensation matters. Specifically, the issue of reasonable owners’ compensation often comes up in federal tax inquiries. But it may also be an issue in shareholder disputes and divorce cases.
Adjusting an owner’s compensation
When an owner takes cash out of a business, it will likely affect the company’s value. There’s less cash on hand to fund growth opportunities or pay off debt. This is why an owner’s compensation can be an issue during shareholder disputes or divorce settlements.
In these situations, courts may award amounts to noncontrolling stakeholders — such as dissenting shareholders or a former spouse — based on the manufacturing company’s value. Likewise, compensation levels may affect child support and alimony payments.
In such cases, it may be appropriate to adjust an owner’s compensation. Adjusted compensation levels reflect the amount the owner could expect to receive for performing comparable duties at an unrelated business entity.
When making an adjustment, it’s critical to consider all types of compensation, including W-2 wages and bonuses, benefits, profit sharing, stock options, and other perks. Dividends (or distributions) and low-interest loans the business makes to owners and other related parties could represent other forms of compensation.
The IRS also may question whether business deductions for an owner’s compensation are reasonable for tax purposes. For C corporations, the primary issue is whether the company is overpaying deductible W-2 compensation to owners to avoid double taxation on nondeductible dividends. For certain pass-through entities, such as S corporations, the IRS looks for the reverse: companies that are underpaying owners to avoid payroll taxes on W-2 compensation and instead classifying payments to shareholders as distributions, which aren’t subject to payroll tax.
Determining what’s reasonable
Salary levels can vary significantly based on an owner’s duties, training and experience. The manufacturing company’s performance and geographic location can also affect pay levels.
The IRS guide Reasonable Compensation: Job Aid for IRS Valuation Professionals provides insight into how to determine reasonable compensation levels. Relevant considerations include:
- External salary surveys, such as Willis Towers Watson’s executive salary surveys, the Risk Management Association’s Annual Statement Studies® and Economic Research Institute’s quarterly salary surveys,
- Compensation data from comparable companies — for example, the ratio of overall owners’ compensation to comparable company sales,
- A taxable income comparison, such as how the compensation affects the company’s taxable income, and
- The ratio of owners’ compensation to median employee compensation.
The guide emphasizes how objective market data can be used to estimate reasonable compensation. In addition to the sources listed, also consider studies published in trade journals and interviews with headhunters who specialize in the manufacturing industry.
It’s important to protect your manufacturing company against a challenge from the IRS. Here are some steps you might take:
- Find out what comparable manufacturers are paying owner-employees,
- Compare financial data from other manufacturing companies,
- Keep records of job responsibilities,
- Spell out reasons for paying high compensation in corporate minutes, and
- Consider tying compensation to company performance.
Remember to pay reasonable amounts for services actually rendered. These actions should provide sufficient protection if the IRS ever comes calling.
Complex and sensitive
Deciding what’s reasonable compensation for a manufacturing company’s owner can be complex and sensitive. But it’s important to do to protect against possible IRS challenges as well as to be prepared if shareholder disputes or a divorce should occur in the future. Call us at 330-453-7633 for more information.
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