Tax law is one of the most complicated aspects of the United States legislation. There are rules regarding how the IRS can operate, how different tax payments are calculated, what constitutes an avoidance of tax payment, and how to go after delinquent taxpayers. One of the issues that you might run into is the concept of unreasonable compensation. This has become a more serious issue in recent years, resulting in the IRS looking closely at the compensation of company executives.
If you believe you may be the target of an unreasonable compensation investigation, you should talk to an attorney. They will be able to explain the situation, whether you have anything to worry about, and how you can avoid raising red flags in the future. They can also take you through the investigation process so that your rights are respected. If you are accused of wrongful compensation, your lawyer will create a defense strategy.
There are three main types of entity that the IRS tends to look at heavily when pursuing wrongful compensation cases. These include:
Each of these situations is approached somewhat differently by the IRS. In each case, they’re looking for tax liabilities and tax evasion, but the method by which the taxes are evaded varies.
With C corporations, business owners and shareholders can avoid paying taxes by overpaying the employees who own shares. There are tax laws that allow C corporations to deduct any income that they pay in compensation to their employee shareholders. But the income has to be “reasonable.”
The key is for the investigator to find something called a disguised dividend. This is when a company is making a taxable profit, but they pay it out as compensation instead. Compensation is deductible income, but dividends aren’t. If the IRS finds income that should have been reported as a dividend, they may send the corporation a tax bill based on the dividend amount.
This means that you will lose the tax exemption on the income. In addition to paying back taxes, you’ll need to pay penalties and interest.
S corporations operate differently. In this case, the IRS is looking for signs that the employee shareholders are being underpaid. If the salaries are too low, that might indicate that they are funneling extra income into shareholder profit distributing.
Distributions are not classified as payroll taxable income. But a regular paycheck is. An employee might take extra distributions and a lower salary just so that they don’t have to pay federal taxes on the majority of their income.
Just like with C corporations, S corporations are bound to make their compensation “reasonable.” The definition of reasonable might vary, but it can’t include severely underpaying employees.
Nonprofits are entities that specifically do not generate a profit. The money they make goes back into the operation. They are subject to strict reporting standards, including the need to account for exactly what they do with every dollar in their budget.
The biggest red flag that the IRS looks for in nonprofits is key employees raising their own salaries beyond a reasonable level. In doing so, they effectively profit off of the nonprofit funds.
When the IRS finds unreasonable compensation among nonprofit executives, it qualifies the amount as “excess benefit transactions.” This is then given excise taxes. The person who received the compensation must pay a 25 percent tax, and the nonprofit managers that allowed the issue to happen unchecked will be given a 10 percent tax.
In these cases, you’ll only need to pay the excise tax based on whatever amount is considered “in excess.” Anything below that is not subject to the penalty. It’s important for nonprofit employees and accountants who work with nonprofits to understand the liability that they might have for excess compensation.
You might be shocked and offended to have your pay rate questioned by a federal auditor. But you shouldn’t react out of anger. Don’t say anything to them except that you’re going to consult with your lawyer. Then contact an attorney.
IRS investigators are trained to gather incriminating evidence from everything they do. That includes not just documentation, but also interviews. Everything you say will be twisted and used in the case against you. You can’t help yourself without legal counsel.
A skilled attorney may be able to defend you against the accusation by proving that you are not unreasonably compensated. They can point out your duties, accomplishments, qualifications, and role in the company. Documenting your value to the company is an essential part of proving that you are worth your salary.
There’s more to your defense than your prior experience and education, too. You might demonstrate to the IRS that you have industry connections and a reputation that the company can’t afford to lose. Similarly, if you’re good at communicating, you’ll be a valuable employee of any organization.
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