What Does the IRS Consider Unreasonable Compensation?
- Steve Julal
- Jul 22
- 2 min read
Incorporating offers small and midsize businesses benefits such as enhanced reputation, personal asset protection, and the ability to offer stock options to attract talent. However, while incorporation can offer these perks, it also introduces new tax-related risks. One of the most commonly overlooked is the issue of reasonable compensation.
The C Corporation Dilemma
Once your company becomes a C corporation, you do have some flexibility in how you pay owners and top executives typically through a mix of salary (compensation) and dividends. Since salaries are tax deductible for the business and dividends are not, it might seem tempting to lean heavily on compensation.
However, this approach may draw attention from the IRS. If the agency determines that a company is characterizing nondeductible dividends as deductible wages to reduce tax liability, it may intervene. The IRS can audit the business and reclassify some of the wages as dividends, which may result in penalties, back taxes, and interest. Additionally, the company could lose the tax deduction for the portion deemed ineligible.
Disputing the IRS’s findings is possible, but it’s rarely simple. Legal battles are time-consuming, expensive, and the outcome isn’t always in your favor.
The S Corporation Dilemma
The reasonable compensation dilemma for S corporations is distinct but still relevant. Income from S corporations typically passes through to owners and is not subject to payroll tax. As a result, some S corporation owners opt to take distributions instead of salary. If the IRS determines that an owner's salary is disproportionately low, it may assert that the business is underpaying wages to reduce payroll taxes, which could lead to a reasonable compensation review.
What Counts as “Reasonable”?
Unfortunately, there’s no hard rule or formula to determine what “reasonable” means. Courts and the IRS typically consider a variety of factors, such as:
The nature and extent of the employee’s responsibilities
The individual’s experience and qualifications
The company’s size and complexity
The relationship between compensation and business performance (sales, profits, and net worth)
Broader economic conditions
Salaries for similar roles at comparable businesses
Whether the employee helped secure company loans or personally guaranteed debts
The business’s compensation practices overall
The company’s financial health
A Real-World Example
The Situation
In a recent U.S. Tax Court case, the owner of a construction company (a C Corp.) received $5 million in bonuses in both 2015 and 2016, on top of a generous salary. The business justified these payouts by pointing to the owner’s role in its turnaround and success.
The Verdict
The IRS disagreed, labeling the bonuses excessive. The court ultimately sided with the IRS, reducing the allowable bonuses to $1.36 million for 2015 and $3.68 million for 2016 (TC Memo 2022-15). The company had to deal with the fallout — a tough and costly lesson on how compensation decisions can come under scrutiny.
Plan with Confidence
When considering incorporation, assess tax implications as well as legal and financial advantages. Properly structuring is essential to maintaining compliance and preventing unforeseen complications in the future.
Need help evaluating whether incorporation makes sense for your business? Want to know if incorporation is right for your business? Contact us! We’ll walk you through the pros and cons, and help you build a compensation plan that holds up under IRS scrutiny.
