Dealership owners, understandably, want themselves and top executives to be compensated fairly for their work, results, and interest. So how do you achieve that goal without attracting undue IRS scrutiny and claims of inappropriate compensation?
Compensation is affected by the amount of cash in your dealership’s bank account. But just because your financial statements report a profit doesn’t necessarily mean you’ll have cash available to pay owners a salary or make annual distributions. Net income and cash on hand aren’t synonymous.
Other business objectives — for example, buying new equipment, repaying debt, and sprucing up your showroom — will demand dollars as well. So, it’s a balancing act between owners’ compensation and dividends on the one hand, and capital expenditures, expansion plans, and financing goals on the other. Therefore, it is essential to maintain an appropriate cash management system within your dealership, if you are wanting to pay compensation to an owner or top executive. A few ways to go about doing this are as follows:
C corporation challenges
If you operate as a C corporation, your dealership is taxed twice. First, business income is taxed at the corporate level. Then it’s taxed again at the personal level as you draw dividends — an obvious disadvantage to those owning C corporations.
C corporation owners might be tempted to classify all the money they take out as salaries or bonuses to avoid being double-taxed on dividends, but the IRS is wise to this strategy. They’re on the lookout for excessive compensation to owners and will reclassify above-market compensation as dividends, potentially resulting in additional income tax as well as interest and penalties. These types of transactions are known as “constructive dividends” which are taxable. These constructive dividends typically arise as a result of the following:
The IRS also monitors a C corporation’s accumulated earnings. Much like retained earnings on your balance sheet, accumulated earnings measure the buildup of undistributed earnings. If these earnings get too high and can’t be justified as needed for such things as a planned expansion, the IRS will assess a tax on them (up to 20% of the earnings). Per IRS Publication 542, the standard amount of accumulated earnings that is considered exempt from this tax is $250,000. However, this amount is subjective and can vary based on what can be considered reasonable for each business. For example, if a company was planning a large acquisition that would cost the company $400,000, then any accumulated earnings in excess of the standard amount could be considered reasonable for that business. Therefore, the excess could then be exempt from this tax.
Know your flow-through
Perhaps your dealership is structured as an S corporation, limited liability company, or partnership. These are all examples of flow-through entities that aren’t taxed at the entity level. Instead, income flows through to the owners’ personal tax returns, where it’s taxed at the individual level.
Dividends (typically called “distributions” for flow-through entities) are tax-free to the extent that an owner has tax basis in the business. Simply put, basis is a function of capital contributions, net income, and owners’ distributions.
So, the IRS has the opposite concern with flow-through entities: Agents are watchful of dealer-owners who underpay themselves to avoid payroll taxes on owners’ compensation. If the IRS thinks you’re downplaying compensation in favor of payroll-tax-free distributions, it’ll reclassify some of your distributions as salaries. In turn, while your income taxes won’t change, you’ll owe more in payroll taxes than planned — plus, potentially, interest, and penalties.
Beware of eyebrow-raisers
Above- or below-market compensation raises a red flag with the IRS — and that’s always undesirable. Not only will the agency evaluate your compensation expense — possibly imposing extra taxes, penalties, and interest — but a zealous IRS agent might turn up other challenges in your records, such as nonsalary compensation or benefits.
What’s more, it might cause a domino effect, drawing attention in the states where you do business. Many state and local governments face budget shortages and are hot on the trail of the owners’ compensation issue. State and local governments will often follow federal audits to assess additional taxes when possible.
Per IRS Publication 535 (Business Expenses), the IRS states that the compensation amount must satisfy two different tests: 1) The compensation must be reasonable and 2) The compensation must be for services performed. The compensation is deemed reasonable by IRS standards based on the duties performed by the executive, the volume of business handled, the amount of responsibility for the job, the complexity of the business, time required, cost of living, company policy, history, and so on.
Other parties also might have a vested interest in how much you’re getting paid. Lenders, franchisors, and minority shareholders, for instance, could think you’re impairing future growth by paying yourself too much.
Plus, if you or your dealership are involved in a lawsuit, the courts might impute reasonable (or replacement) compensation expense. This is common in divorces and minority shareholder disputes. In these situations, you’d be wise to consult an attorney early in the compensation decision-making process.
Best Practices
A common best practice when it comes to executive compensation is requiring approval from the board of directors or shareholders that have voting rights. This is important as sometimes these individuals often see the bigger picture. Therefore, it is recommended that any compensation changes for executives are approved prior to being granted.
Follow the regulations
When setting executive compensation, you want to be aware of all current IRS regulations and other applicable requirements. Contact one of our auto industry professionals about how federal and state laws will affect your compensation decisions.