[IMGCAP(1)]Small businesses, generally those organized as S corporations or partnerships, can run afoul of IRS guidelines governing “reasonable compensation” for individuals who are both owners/shareholders and employees of these companies.

Traditionally, compensation issues have arisen when the IRS has challenged “excessive compensation” with owners of regular “C” corporations. In those cases, the shareholders are often attempting to avoid the double taxation of having income of the corporation taxed at both the corporate level and again as a dividend.

Increasingly, however, compensation issues are arising with small businesses operated as so-called “flow-through entities” and not when an owner/ employee’s salary is too large, but when it is too small. The owner in this case may be attempting to avoid payroll taxes for Social Security and Medicare that would otherwise be due if the compensation had been set higher.

This area is contentious and litigious, and it has been in the news lately. The Tax Court has found salaries of some owners/employees (including some well-known individuals) to be unreasonably low, and assessed interest, penalties and liability for additional payroll taxes. This issue will likely remain relevant as many small business owners feel the pinch of higher payroll taxes now in effect to partially fund the cost of health care reform.

“Reasonable compensation” is not always clear-cut, but the IRS and courts have articulated principles and guidelines addressing this issue. Further, some members of Congress want to tighten up this area, which they view as a loophole.

Here are some best practices to keep in mind.  They were compiled by American University’s Kogod Tax Center and are based on recently litigated cases addressing reasonable compensation for small business owners. But remember, “reasonable compensation” is open to interpretation, and so the IRS and the courts are likely to consider the context of the facts and circumstances, and no single factor likely will be determinative.

1. Pay market rate salary. Compensation should be set at the fair market value for the services that the small business owner is providing to the business. “Fair market value” means representative of what the company would have to pay someone it hired to perform these services, or the amount the owner could reasonably ask for his or her services if working in a similar capacity elsewhere.

2. Put it in writing. A written employment agreement should be in place documenting the services to be provided.

3. Get an objective opinion. The employment agreement should be arrived at in good faith and at arm’s length. Someone other than the owner/employee, such as a non-interested third party, should participate in establishing the agreement’s criteria and the value of the services.

4. Pay up … or document why you cannot. The business needs to make payments under the terms of the agreement, or else document the reasons explaining why compensation was not paid. In other words, honor the terms of the agreement.

5. Don’t discount your qualifications. The compensation should reflect the owner/employee’s actual qualifications. For example, the compensation that is set for someone with many years of experience in his or her industry and who supervises others should be higher than someone just entering the job market.

6. Assess goals and business conditions. Compensation should be commensurate with the owner/employee’s duties, hours, scope of responsibilities, expectations (for example, to expand into new markets, recruit experienced new hires), complexity of the business and business conditions at the time the agreement is reached.

7. Compare comp to other metrics. Evaluate the compensation paid to the owner/employee in relation to other metrics within the company’s possession such as gross and net income, distributions paid to shareholders (including the owner/employee), and compensation paid to non-owner employees.

8. Measure comp over time. Track the compensation of the owner/employee over a number of years and evaluate whether and by how much it has increased as the company has grown and achieved its goals.

9. Compare business to others in industry. Consult annual studies (or hire an expert to do so for you) that provide information on the profitability of comparably sized businesses in your industry. If your company’s profit is much higher and your compensation is low, it may indicate you have a “reasonable compensation” issue that could attract the attention of the IRS.

10. Compare your role to others in industry. Consult annual studies (or hire an expert to do so for you) that compare your company’s financial results to others in your industry based on such criteria as taxable income, and compare the owner/employee’s salary to those of workers in your profession at levels equal to, above and subordinate to the owner/employee’s position.

David J Kautter is managing director of the Kogod Tax Center at American University’s Kogod School of Business. He formerly served as Ernst & Young's director of national tax.