The concept of reasonable compensation is integral to a startup’s financial management and tax obligation. It refers to the fair and justifiable pay that founders or employees earn as part of their work within the company.
But determining reasonable compensation is more than just paying yourself and other employees what you think is fair or can afford. Because corporate compensation is a business expense, you must adhere to various IRS code Section 162(a) guidelines. The IRS established these guidelines that prevent business owners, individuals, or founders from under- or overpaying themselves or employees to reduce tax liability.
This post breaks down the concept of reasonable compensation and how startups can make informed decisions.
What is Reasonable Compensation?
Reasonable compensation is the fair and justifiable payment for employees and founders as part of their work. Different factors impact the compensation rates, including:
- Time requirements
- Employees’ achievements
- Business volume
- Complexities of tasks
In short, the IRS requires that salaries correlate to the value and services provided. When applied to founders, these hypothetical amounts should also be comparable to what a third-party manager or executive performing similar tasks would demand.
Why Does Reasonable Compensation Matter?
Reasonable compensation matters since it directly impacts the corporation’s and its founders’ tax obligations. Underpayment (or overpayment) often leads to misrepresented income levels, which can reduce tax liability but trigger IRS audits or penalties.
Adhering to reasonable compensation and paying salaries that align with industry standards minimizes the risks of scrutiny from the IRS.
Best Way to Determine Reasonable Compensation
Different startups employ different techniques to determine reasonable compensation. Here are popular methods for calculating fair wages.
Compensation benchmarking is one of the best ways to determine reasonable compensation. These industry benchmarks provide valuable data on standard or specific roles within the sector. These benchmarks offer insights into the current compensation rates for similar positions.
The comparable salary approach analyzes the salaries of individuals in similar roles within the company. It compares them to what professionals in similar positions earn in other startups. The process examines each role’s job skills, responsibilities, and experience.
Job Roles and Responsibilities
The last determining factor for reasonable compensation is looking at specific job roles and responsibilities. This approach involves assessing employees’ duties and responsibilities to create a fair and equitable compensation structure. Moreover, the method analyzes other underlying factors such as KPIs, skill sets, role analysis, and internal consistency.
The Role of Board Decisions and Expert Opinions
Another powerful tactic for determining reasonable compensation is through board decisions and expert opinions. The board considers compensation packages, company performance, industry norms, and the startup’s financial health.
Board decisions go a long way in maintaining high transparency and governing compensation discussions to ensure fairness and compliance.
Another source of authority for finding reasonable compensation is through expert opinions. Seeking expert support from HR specialists can provide invaluable guidance on the best packages. These experts conduct in-depth analyses of job roles, industry standards, and market conditions to provide data-driven recommendations.
Documentation and Record-keeping
Transparency, documentation, and record-keeping help startups set fair pay levels and justify their decision-making as part of tax compliance. Good record-keeping keeps businesses accountable for their choices while providing defense during audits or disputes.
Avoid Pitfalls of Inaccurate Reasonable Compensation
Good communication forms the cornerstone of any compensation decision. The consequences of common compensation mistakes can be harsh. Fortunately, there are some powerful strategies to mitigate risks.
Consequences of Over or Underpayment
Both businesses and employees face consequences for over or underpayment. Of course, overpayment impacts the startup’s finances and cash flow, potentially jeopardizing its growth potential. But it can also artificially reduce the company’s tax liability when treated like a business expense.
Conversely, underpaying employees, managers, and founders brings scrutiny from the IRS since it limits their individual tax liability. This situation typically occurs with founders and partners but could lead to legal issues, audits, or penalties.
Strategies to Mitigate Risks
Fortunately, research, transparency, and expert insight can help mitigate the risks of unreasonable compensation. For one, thorough research on industry benchmarks and salary data can ensure the compensation package aligns with market standards.
Further, regular compensation package reviews ensure that salaries and stock options align with the current market conditions and fit the startup’s business model. These actions ensure that wages remain fair and competitive.
Search for Expert Insights When Determining Reasonable Compensation
Business owners and startup founders often need help navigating the complexities of reasonable compensation. Because the tax implications of getting compensation wrong can be significant, professional guidance can be a decisive strategic move.
At Founder’s, our expert team can help you determine what proper, reasonable compensation means for your business to avoid IRS scrutiny. Contact us at Founder’s today to get expert guidance on reasonable compensation.