Construction is a high-risk industry. Many contractors convert their businesses to C corporations to avoid personal liability for financial claims against their companies. Although doing so makes sense from a risk management perspective, it can put construction business owners (shareholder-employees) in a precarious tax position regarding their compensation.

Crux of the issue

Generally, C corporations pay shareholder-employees some combination of compensation and dividends. They usually want to pay these parties more in compensation than in dividends because compensation is tax deductible, while dividends aren’t. What’s worse, dividends are subject to “double taxation”—that is, they’re taxed once at the corporate level and again on the recipients’ individual tax returns.

Enter the IRS. If it believes a C corporation is paying shareholder-employees “excessive” compensation, the agency may challenge the company’s approach as providing dividends in disguise. Such challenges typically begin with an audit and can go as far as the U.S. Tax Court.

The issue of excessive compensation springs from Internal Revenue Code Section 162. It allows corporations to deduct only “a reasonable allowance for salaries or other compensation for personal services actually rendered.” In other words, compensation must be based on work performed and not, for example, a shareholder-employee’s percentage of ownership in the business.

If the IRS can prove that a shareholder-employee’s compensation was excessive for the work performed, it may recharacterize all or part of it as dividends. This will likely result in higher taxes and could trigger penalties and interest for underpayment.

Reasonableness factors

Disputes over the proper characterization of compensation to C corporation shareholder-employees have led to much litigation over the years. The resulting case law identifies several factors relevant to evaluating whether compensation is reasonable and not excessive. These include:

The shareholder-employee’s role. How important is the individual to the company? This factor includes the shareholder-employee’s qualifications, expertise, hours worked, and duties performed. It also considers whether the person handles multiple functions for a single salary and was substantially underpaid in the past—for instance, while the business was getting off the ground.

Compensation at comparable businesses. In an industry context, this factor would examine payments to owners of similar construction companies in similar executive positions. A court might look to benchmarking data, surveys, job listings, or formal studies. This factor may not be relevant, though, if the shareholder-employee fills a unique role for which “comps” aren’t available.

Business characteristics. The company’s “size” in terms of sales, net income, or value plays a role in the reasonableness determination. Is the business in good financial condition and growing steadily? How does it compare to similar construction companies? Strong operational performance can help justify an ostensibly excessive salary. General economic conditions and the complexities of the specific business are relevant, too.

Internal compensation consistency. Courts have looked for evidence of internal inconsistencies in how a company compensates employees, whether shareholders or not. For example, bonuses awarded to shareholder-employees that are inconsistent with an established compensation program may indicate excessive compensation. Courts will also likely question salaries paid to shareholder-employees that seem to be a function of ownership rather than management responsibility.

Conflicts of interest. This factor may come into play when the individual in question is the sole owner or controlling shareholder. For instance, providing large bonuses or distributions of all or most of a company’s pretax earnings to a shareholder-employee, but not non-shareholder-employees (such as managers), may indicate an attempt to distribute income through excessive compensation.

Conflicts of interest have become such an important factor that they’ve given rise to the “independent investor” test. This test asks whether a hypothetical (nonemployee) investor would be satisfied with the return on equity after shareholder-employee compensation is paid. If the remaining return is unreasonably low, it suggests that some compensation may be excessive and represent a disguised, nondeductible dividend rather than reasonable pay for services rendered.

Help is available

If your construction business is structured as a C corporation, stay vigilant regarding the issue of excessive compensation. And if you’re considering converting to a C corporation, assess the risk of IRS challenges in your due diligence. In either case, your CPA can help you design and maintain a compensation plan that’s likely to withstand scrutiny.

S corporations: The other side of the compensation coin

Construction business owners who run C corporations must beware of paying themselves excessive compensation in the eyes of the IRS. (See main article.) Those who run S corporations face the other side of the coin.

Generally, S corporations pay shareholder-employees some combination of compensation and profit distributions. These business owners usually want to receive less compensation and more distributions because of the 15.3% federal payroll tax on compensation. IRS rules, however, require S corporations to pay shareholder-employees “reasonable” compensation for their services before allowing nonwage distributions.

To determine whether compensation for an S corporation shareholder-employee is reasonable, the IRS assesses the main source of the company’s gross receipts, which may be:

• Shareholder-employee services,
• Non-shareholder-employee services, or
• Capital equipment.

To the degree that gross receipts come from the work of non-shareholder-employees and capital equipment, payments to a shareholder-employee are rightly characterized as nonwage distributions. These payments aren’t subject to payroll tax.

However, if shareholder-employees are the primary driver of gross receipts, their payments will probably be classified as wages. The IRS also typically considers compensation for administrative work performed by a shareholder-employee to be wages.

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