COMPENSATING THE BOSS

COMPENSATING THE BOSS

by Mark E. Battersby

Photo

The IRS has long been on the lookout for compensation that is not “reasonable.” That means a business paying the owner a relatively small amount may be attempting to reduce the operation’s payroll tax burden. Excessively rewarding an individual could result in shifting income that will be taxed in a lower bracket.

Business owners can pay themselves through a draw, a salary, or a combination of both. A draw is a direct payment by the business. A salary is considered part of the pressure cleaning operation’s payroll and taxes are withheld. Obviously the IRS expects that compensation to be “reasonable,” neither too much nor too little.

REASONABLE COMPENSATION

To be considered reasonable by the evervigilant IRS, the amount paid for the performance of services must be equivalent to what a similar business would pay to someone performing similar services. In other words, reasonableness is determined based on all of the facts and circumstances.

The role of the individual, either the owner or employee, in the pressure washing business and those paid by similar businesses for similar services are all factored into the decision along with the character and condition of the business.

WAGES

The most glaring potential trap is largely limited to publicly traded companies that are barred from deducting any applicable employee renumeration in excess of $1 million annually. The Tax Cuts and Jobs Act (TCJA) expanded the scope of “publicly held corporations” to include all forprofit businesses required to file reports with the Securities and Exchange Commission.

An officer in an incorporated pressure cleaning business is generally an employee. Of course, an officer who performs no services or only minor services and who neither receives nor is entitled to receive any pay is not considered an employee.

Any distribution to shareholders from earnings and profits is generally labeled as a dividend. A dividend is not, however, taxable distribution if it is a return of capital to the shareholder. Most

distributions are in money, although they may also be in stock or other property.

A loan by a corporation to a corporate officer should clearly be a loan made at arm’s length. There should be a contract with a stated interest rate, a specific length of time for repayment, and a consequence for failure to repay. A below-market loan is a loan which provides no interest or an interest rate below the federal rate.

An incorporated pressure washing operation or business that issues a shareholder—or an employee—a belowmarket loan must, depending on the circumstances, treat the repayment as a gift, a dividend, distribution of capital, payment of wages, or other payment. Plus, like other payments, it must be reasonable.

With a family-operated or closely held pressure cleaning business, reasonable compensation issues arise because the owner can allocate compensation payments as one of the following:

• Compensation for services performed, tax deductible as a business expense, or

• Compensation for a return on their capital investment such as dividends and distributions, which are not a deductible business expense.

In other words, a contractor or business owner can manipulate the operation’s income by deducting a shareholder’s compensation rather than labeling it as a dividend. This is a potential issue as compensation is a deductible business expense, while dividends are not. Thus, deducting shareholder compensation allows the business owner to dictate the bottom-line income of the closely held business.

COMPENSATION DISGUISES

Generally, the owner/employee of a profitable pressure cleaning business should receive both wages and dividends. Dividends—whether cash, stock, or other assets—are not, of course, taxed if it is a return of capital. But there are those socalled “constructive” dividends.

A constructive dividend is a payment, allowance, loan, or other form of financial benefit from a business to an owner, shareholder, or key employee that may not be intended as a dividend but which may be classified by the IRS as a dividend.

The classification can happen retroactively at any time with the recipient of the constructive dividend holding an added tax bill. Even worse, constructive dividends can range from expense reimbursements to use of the pressure cleaning operation’s property such as vehicles, residences, airplanes, or boats. Forgiveness of loans from the business or the assumption of shareholder or owner debt, loans made at below-market interest rates, as well as excessive compensation and payments to an owner or shareholder’s family members can be retroactively labeled as constructive dividends.

Naturally, this classification is unfavorable for the recipient since it makes the financial benefit taxable—even if the recipient did not receive liquid financial compensation. If the owner or shareholder reimburses the pressure washing business for the fair market value of the benefit, the IRS will not count the benefit as a dividend.

OTHER TAKE-OUT STRATEGIES

Typically, the owners of closely held, incorporated pressure cleaning businesses can avoid double taxation if the business pays most of its profits in the form of a bonus or by leaving profits in the business as accumulated earnings. The IRS, obviously, has a field day re-characterizing bonuses as a nondeductible dividend.

The failure of a business to make nondeductible payments of sufficient dividends relative to profits can subject incorporated pressure washing businesses to the accumulated earnings tax, a penalty for retaining alreadytaxed profits in the business rather than distributing them as dividends.

Many owners choose to lend themselves money through their business. These so-called “shareholder loans” must have a stated interest rate, a maturity date, and covenants for non-repayment. Not too surprisingly, there is some risk, such as if the interest rate is below market, in which case it may be

treated as a gift, dividend, contribution to capital, payment of wages, or worse.

A business owner can, of course, choose an owner’s draw. Unlike W-2 wages, a draw is not taxed at the company level. A sole proprietor or partner’s income is a draw although an owner’s draw can be made from an LLC or even an S corporation.

Since draws are not taxed, largely unanswered is the question of what amount is appropriate for the owner of a pressure washing business?

DIVIDENDS VS EMPLOYEE COMPENSATION

The profits of a closely held business can be distributed as either wages or as dividends. Double taxation, once at the corporate level and once at the shareholder level, is an expensive problem for many owner/employees even with the pass-through income deduction.

Owner/employees must, of course, include some—but not all—of the amounts received from their business

in their taxable income, although the tax rate usually varies depending on the type of payment. The pressure cleaning business can generally claim a tax deduction for some but, again, not all of those amounts distributed and/or paid to owner/employees as wages or salaries. Dividends paid by the business to shareholders are not tax deductible by the business.

REASONABLE OR UNREASONABLE?

When it comes to determining the reasonableness of anyone’s salary, the IRS has failed to provide pressure cleaning contractors and business owners and shareholders/employees with specific guidance. This has left many small business owners and their tax advisors resorting to various rules of thumb instead of basing their figures on empirical data.

Not too surprisingly, the courts are often asked to determine what is “reasonable.” According to many experts, the factors the court weighs include compensation of nonowner employees, past salary history, industry formulas, and the financial condition of the business. However, even though all these factors are considered, the court’s most heavily weighted consideration appears to be summarized as the replacement cost to the company of hiring an outside party to perform the business owner’s duties.

PASS-THROUGH BUSINESS INCOME

The qualified business income deduction (QBI) is a unique tax deduction that allows eligible self-employed and small business owners to deduct up to 20 percent of their qualified business income. The owners of pass-through businesses such as S corporations, partnerships, sole proprietorships, and LLCs, where profits pass through to the owners to be taxed at their level, may be able to deduct up to 20 percent of their QBI.

Of course, how much the owner makes helps determine whether or not a full or partial deduction can be taken. In general, total taxable income in 2024 must be under $191,950 for single filers (up

from $182,100 in 2023) or $383,900 (up from $364,000) for joint filers. For those over these limits, the IRS’s complicated rules determine whether the pressure cleaning operation’s business income qualifies for a full or partial deduction. Naturally, not all income is qualified business income. Capital gains or losses, dividends, interest income, income earned outside the U.S., and certain wages and guaranteed payments made to partners and shareholders are not QBI.

In order to both profit from and avoid the potential pitfalls of reasonable compensation in the face of accumulated earnings, early planning is essential before an audit results in headaches and expensive penalties. Seeking professional guidance for reaping those tax breaks due to you, the owner/employee of your pressure cleaning business, can ensure that you don’t run afoul of the tax laws in this area CT