Due diligence and executive compensation: Supporting the reasonableness of salaries
Executive compensation can be a sensitive subject in a merger or acquisition. In addition to negotiating salaries with owners at the target business, the parties must also consider that the IRS might challenge the reasonableness of pre-transaction payments to owners and officers to determine if they’re properly characterized as compensation or dividends. The compensation paid to the owners after the transaction may provide some evidence of the reasonableness of compensation paid before the transaction. This is especially true if the roles and responsibilities of the owners after the transaction remain similar to the roles and responsibilities of the owners before it.
If the IRS concludes that wages are unreasonably high and dividends too low, the reclassification of salary expense to distributions will increase a C corporation’s taxable income and possibly subject the business to additional tax, penalties, and interest. If an examiner finds that wages are unreasonably low, which is typically the concern at S corporations, the resulting reclassification can result in exposures for failure to withhold payroll taxes.
Ongoing Risk for Incoming Ownership
In a stock transaction, the IRS and applicable states will likely pursue the business for any unpaid taxes, penalties, and interest. While an asset transaction can protect the acquirer from some prior federal income tax liabilities, a surviving entity could be held liable for unpaid payroll taxes and some state income taxes regardless of how the deal is structured.
What to look for
There’s no bright-line test that the IRS uses to calculate the proper balance between salaries and dividends. It evaluates the facts and circumstances of each case to determine if the amounts paid in salary are reasonable compensation for the work performed. Examiners consider the relationship of the parties and the intent of the employer as well as amounts ordinarily paid by similarly situated enterprises.
There’s no bright-line test that the IRS uses to calculate the proper balance between salaries and dividends.
Pre-transaction, an acquirer should look at salaries and dividends to confirm that they accurately reflect the balance between compensation for work and distributions of corporate earnings. Post-transaction, the acquirer needs to consider how changes in executive compensation could be used as evidence for/or against the reasonableness of salaries.
What to do about it
In the event that executive compensation prior to the transaction seems likely to be considered unreasonable by the IRS, the acquirer should take steps to protect itself from exposure in the transaction documents. This may require quantifying the potential historical exposure so that protections, such as escrows and holdbacks, can be negotiated. The potential exposure also may need to be quantified in order to book uncertain tax positions on the opening balance sheet after the transaction.
In order to quantify the exposure, the acquirer must determine the reasonableness of compensation prior to the transaction. An acquirer typically has some perspective on the roles and responsibilities of the owners who stay on after an acquisition since it negotiates the responsibilities and compensation as part of the transaction. However, it often needs to thoroughly analyze past compensation practices since it was not involved in salary decisions before the transaction. As a result, this analysis can be difficult.
The acquirer should consider compiling a detailed description of an outgoing owner’s pre- and post-transaction responsibilities and understand how an IRS examiner would review the classification of payments to that individual. There are many legitimate reasons for an owner’s compensation to change significantly as a result of the merger or acquisition. The former owner frequently takes on a reduced role that results in a reduction in salary. When that happens, it’s important to document how the reduction is justified based on the person’s post-transaction responsibilities and, to the extent information is available, how the person’s salary compares with executives in similar businesses.
An analysis of executive compensation is an important consideration in many transactions. If you have any questions, please give us a call.