One of the most generous tax deductions available to businesses, as well as not-for-profits, is the ability to deduct an employee’s pay. For the most part, this is not controversial. After all, all but the smallest companies need to have employees to help with the running of the business’s affairs. So, the IRS and other authorities will generally allow compensation to be deducted as a necessary business expense, so long as the employees in question are legitimately on the company’s payroll. However, these matters can become more complicated as businesses grow and their top leaders demand higher pay.
All compensation must be reasonable in the eyes of the IRS before it will allow a deduction. This means that, at the time the employee and employer agreed on the compensation to be paid, the wage must have seemed commensurate with the type and volume of the work being performed. The IRS actually evaluates a number of factors when deciding whether compensation is reasonable.
Obviously, whether compensation is reasonable is ultimately a question that depends on the circumstances. The reasonableness of an executive’s pay can even be the subject of a tax controversy, as the IRS will be more likely to challenge a deduction when the end result could be tens of thousands of tax dollars.
To give a black and white example, though, an executive of a not-for-profit with a $10 million a year operating budget is probably receiving reasonable compensation if she receives $100,000 a year and puts in 45 to 50 hours a week on average. On the other hand, the same person who receives $1 million a year for spending 20 hours a week on a not-for-profit with $3 million operating budget might not be receiving reasonable compensation.
There can be a lot at stake when tax controversies arise. Those in the White Plains area who have questions about compensation should consider speaking to a tax attorney, especially if they are presently or expect to be the target of an audit.