If you haven’t heard the news, the federal government is a little short of money after racking up multiple annual trillion-dollar deficits. A trillion here and there, and after a while, someone might figure out the government may have to become financially more responsible. I am not sure if it is a direct result of the government’s inability to spend within its capacity, but in the past year or so, I have noticed the IRS and Department of Labor (DOL) pursuing the owners of independent insurance agencies more often for not complying, in their opinion, with the reasonable compensation rules.
The rules are difficult to summarize because the IRS has not published specific guidelines in the Code of Regulations. Instead, each case is determined on the facts and circumstances of each case. In general, these two regulatory bodies have the right to determine how much the business owner should be paid. That is correct. They have a right to determine your compensation.
The reason they have this right is because they have the right to enforce tax collection and both want to prevent business owners from moving compensation to different buckets in ways that unrightfully decrease the taxes owed. These rules have been in place for some time but seem to be enforced more frequently now. The IRS and DOL are involved because the IRS wants all its income taxes, and the DOL wants all the appropriate employment taxes, especially now under healthcare reform.
Too Much or Too Little
It does not matter whether the owner is paid too much or too little.
In some situations, taxes can be minimized by taxable wages being too high and, in some situations, taxes can be minimized by taxable wages being too low. The regulators’ goal is to assure that business owners’ compensation is “reasonable.” This means that wages must be appropriate for the services performed.
For example, if you own an agency with $1 million in revenue, personally service a book of $300,000 in commissions and have most management responsibilities, and are paid $300,000 in wages, some would consider you to be overpaid. It is not that $300,000 in and of itself is wrong. It is that $300,000 in wages might not be acceptable because without being an owner, the person likely would not be paid close to $300,000 for this scenario. So the owner’s compensation in this case should be divided between “reasonable” compensation for sales and management, with the remainder being some kind of distribution or dividend.
On the other hand, in this same situation, if the person is paid $50,000 and the rest is paid in distributions, some would conclude the agency owner is underpaid and that “reasonable” compensation would be much higher.
I am sure the reader can see how these two examples would shift taxes. The prosecution by these regulatory bodies of business owners to pay themselves a “reasonable” wage has significant strategic, tactical, and tax planning impact.
Beginning with the tax aspect, agency owners that care to take precautions should develop an executive compensation strategy for the principals. Agency owners should do this by working with their CPAs, but keep in mind that CPAs are not going to have the compensation data necessary to develop a proper plan on their own. For this, the agency will need an industry consultant highly familiar with industry compensation norms. The plan, in my opinion, should then be memorialized and followed.
Regulatory bodies have some rights to set your compensation at the level they see fit if you do not do this, or if they do not agree, and then you have to prove they are wrong. Building a reasonable plan, based on the facts and circumstances specific to your situation, not your buddy’s situation, can help protect you and your agency.
Keep in mind too – they may be able to ask for back taxes and penalties.
On a tactical basis, historically agencies have “bonused” extra compensation to principals or key employees for taxes, life insurance premiums, and other expenses and perks. If the bonus is not specific to the job and services performed, a chance exists now that the regulators will determine the compensation is not reasonable.
On a strategic basis, especially for internal perpetuation planning, the need to comply with reasonable compensation rules can drastically change an agency owner’s plans.
Often, owners will take much less than normal pay so their successors, particularly their kids, can afford to purchase the agency. This strategy may not pass the regulators’ tests. Other times agency owners demand wages far above the fair value of services provided as a way of being paid for the agency. This strategy is unlikely in my opinion to be upheld.
Pay and Perpetuation
When perpetuating an agency, it boils down to everyone involved must be paid a reasonable wage relative to the services they provide. Some considerations are:
- The duties performed by the employee.
- The volume of business handled.
- The character and amount of responsibility.
- The complexities of your business.
- The amount of time required.
- The cost of living in the locality.
- The ability and achievements of the individual employee performing the service.
- The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation.
- Your policy regarding pay for all your employees.
- The history of pay for each employee.
I find some agency consulting firms and other professional advisors are not keeping up with these rulings. As a result, some agency owners are getting bad advice. And reasonable compensation is not just important relative to these regulators. Reasonable compensation is becoming a test in divorces and divorce valuations, and in minority shareholder lawsuits, too.
From a pure business perspective, following reasonable compensation rules may actually cause your business to become more successful too.
Management will likely operate the agency more as a business. Management will likely stop and think before taking all the money out at year-end and consider whether continuing to subsidize unprofitable producers really makes sense if one of the potential risks is an audit. (Many agency owners are paid less than what some would consider reasonable compensation simply because they cannot afford to pay themselves a normal wage while paying underperforming producers what they are paid).
I am not an accountant or an attorney, so nothing within this article should be considered tax or legal advice. It is simply my opinion based on reading various cases, educational material, and experiencing what happens to agencies when a regulatory body decides the agency owners are not paid a reasonable wage.
Note: Nothing in this article should be considered legal or tax advice. All readers should consult their tax and legal advisors before taking any action.