IRS disputes with business owners over shareholder executive compensation is the topic of a recent article titled “Navigating Tax Risks In Shareholder Executive Compensation,”written by principal Natasha Perssico Escobedo, MBA, CPA, AM-ASA, and published on Law360.com. The article also addresses relevant federal income tax statutes and judicial precedents related to shareholder-executive compensation.

In recent years, the Internal Revenue Service has focused on shareholder executive compensation paid to executives who are shareholders in business enterprises, to ensure compliance with employment and income tax requirements. These steps are part of the IRS’ goal to improve tax compliance by corporations and high-income taxpayers. C corporations and S corporations are among the most heavily scrutinized entities.

The IRS requires that both C and S corporations compensate executive-shareholders based on the fair market value of the services rendered. Companies that do not take the appropriate steps to justify compensation paid face the risk that, upon being audited by the IRS, they possibly will be penalized by the IRS’ hefty accuracy-related fine.

To determine the reasonableness of executive-shareholder compensation, experts should consider both statutory authority and judicial guidance. Internal Revenue Code Section 162(a) provides that executive-shareholder compensation is deductible as a business expense if it is reasonable in amount and based on the services rendered.

For executive-shareholder compensation to qualify as reasonable employee compensation, Treasury Regulation 1.162.7 provides that executive-shareholder compensation for personal services should be an ordinary and necessary expense, paid or incurred by the corporation in connection with carrying on any trade or business, be reasonable in amount and based on personal services rendered. Companies and their corporate counsel are advised to support compensation paid to executive-shareholders by carefully documenting each executive’s qualifications, duties and key accomplishments.