Reasonable compensation is a term you want to be familiar with when valuing your company and your shareholder compensation. As business owners, we have the privilege and responsibility of setting our own wages. However, how much we take impacts the profits we report on our financial statements.
Why should I use it?
The health of our financial statements impacts all the dealings we have with third parties such as lenders, potential buyers, and vendors. That is why a reasonable compensation must be determined. If shareholder compensation is too high, it can lower the value of the business. If we underpay ourselves it can inflate our business’s value.
Where do I get more information?
In the U.S. the term reasonable compensation is related to payroll tax issues because distributions are not taxed and wages are. The Internal Revenue Service has published a fact sheet that provides factors for determining reasonable compensation. Some of the factors used in determining reasonable compensation include employee training, experience, duties, time spent working in the business, and many other factors. This can also be useful for Canadian businesses that are wrestling with this issue.
What if I have a Nonprofit?
In the case of a charity, reasonable compensation for executives is even more important. If the executive is overpaid, the CRA could determine there is an undue private benefit and levy penalties. If a charity CEO is considered overpaid, it can’t be good for donations. Visit https://www.irs.gov for more details on nonprofit reasonable compensation.
There are many twists and turns to reasonable compensation. If it’s an issue or concern for your business, please feel free to reach out and let us know how we can help.
