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Reasonable Compensation for Law Firms and Attorneys

By Ronald L. Seigneur

A question that arises repeatedly in professional service firms is what constitutes reasonable compensation for employee-owners. For many firms, no single operating expense category impacts the bottom-line enterprise profit as much as the compensation paid to the employee-owners of the enterprise. Clearly, an expense that is discretionary to the owner in terms of its magnitude, timing and method of payment, may represent not only compensation for services rendered, but may also be a disguised dividend or a distribution of profits. The amount of profits paid as compensation determined to be “reasonable” for tax reporting purposes can easily be manipulated by adjusting the compensation paid within the ownership group.

This article is intended to provide some fundamental guidance for attorneys and law firms whenever employee-owner compensation is at issue. In many instances, this focus will relate to ownership decisions regarding the overall allocation and character of enterprise profits, but the same concepts and analytical framework can be of benefit in the assessment of reasonable compensation for other purposes, such as the valuation of a non-compete agreement and in the segregation and measurement of personal/professional versus enterprise goodwill for dissolution of marriage purposes in jurisdictions where this aspect is in play. (See Identifying and Measuring Personal Goodwill in a Professional Practice, by Mark O. Dietrich, CPA/ABV, AICPA CPA Expert, Spring 2005.) Another emerging area where these principles are often applied is in the evaluation of excess or inadequate compensation challenges by the Internal Revenue Service, with respect to closely held C corporations or Subchapter S corporations, respectively. The issue with S corporations paying too little in wages to the owners to allow them to take a larger share of enterprise profits as distributions not subject to employment taxes has received significant recent attention from the Internal Revenue Service on behalf of the Social Security administration. This article provides guidance on what factors would be considered in determinations of reasonable compensation for this purpose.

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