Revenue Ruling 79-39: Taxing Unreasonable Compensation

Revenue Ruling 79-39 provides Internal Revenue Service (IRS) guidance on the tax treatment of compensation paid to shareholder-employees of closely held corporations. This ruling is relevant when the amounts paid are later determined to be in excess of what is considered “reasonable.” It addresses how these payments should be characterized for tax purposes, impacting both the corporation and the individual recipient.

The Core Principle of Revenue Ruling 79-39

The core principle of Revenue Ruling 79-39 is that the intent behind a payment determines its character for tax purposes. If a corporation pays an amount to a shareholder-employee with the clear intent that it is compensation for services, the IRS respects that characterization. This holds true even if a portion of that payment is later found to be unreasonable. The ruling clarifies the payment is not automatically reclassified as a different distribution, such as a dividend, simply because it is deemed excessive.

This position is based on the idea that a transaction’s nature is fixed when it occurs. The corporation and employee-shareholder intended the payment to be salary and documented it as such through payroll, employment agreements, and corporate records. Consequently, the entire payment retains its character as compensation. The issue of unreasonableness affects its deductibility for the corporation, not the fundamental nature of the payment.

The ruling prevents taxpayers from retroactively changing a payment’s nature to gain a more favorable tax outcome. For instance, a shareholder-employee cannot reclassify the unreasonable portion of their salary as a dividend to benefit from a lower qualified dividend tax rate. Revenue Ruling 79-39 ensures the tax treatment aligns with the original intent, regardless of a later reasonableness determination.

Determining Reasonable Compensation

Internal Revenue Code (IRC) Section 162 permits businesses to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” The IRS evaluates several factors to determine if compensation is reasonable, as there is no single formula. The assessment is based on the facts and circumstances of each case, with reasonable compensation defined as “the amount that would ordinarily be paid for like services by like enterprises under like circumstances.”

The IRS evaluates several factors to determine if compensation is reasonable. The analysis considers the facts and circumstances of the situation, including:

• The employee’s qualifications, experience, training, and specific skills.
• The nature, extent, and scope of the work the employee performs, including their duties and responsibilities.
• The complexity of the business and the employee’s role in its success.
• A comparison of the compensation paid to that of similar positions in similar companies and industries.
• The size and financial condition of the paying corporation, as a highly profitable company may justify higher compensation.
• The corporation’s salary policy for all its employees to review for consistency.

Tax Implications for the Corporation and Shareholder

When a portion of a shareholder-employee’s salary is deemed unreasonable, there are tax consequences for both parties. For the corporation, the main impact is the disallowance of the deduction for the unreasonable portion of the compensation. This denial increases the corporation’s taxable income, resulting in a higher corporate income tax liability.

For the shareholder-employee, the entire amount received is treated as wage income, including both the reasonable and unreasonable portions. As a result, the full payment is subject to ordinary income tax rates and applicable payroll taxes, such as Social Security and Medicare (FICA). This is a direct consequence of the ruling’s principle that the payment’s character is fixed by the original intent.

This treatment can lead to a less favorable tax situation for the shareholder than if the excess amount were treated as a qualified dividend. Qualified dividends are often taxed at lower capital gains rates, whereas wage income is taxed at higher ordinary income rates. The ruling ensures the unreasonable portion does not receive this preferential dividend treatment and is subject to full income and payroll taxation.