New Hampshire businesses need to start thinking about documenting what is ‘reasonable compensation’ to the owners or partners if they are operating as a sole proprietor or partnership.
As an indirect result of New Hampshire introducing and ultimately repealing the so-called LLC tax several years ago, New Hampshire has now enacted new rules giving more guidance over what is ‘reasonable compensation’ in the preparation of the Business Profits Tax Return. I’m going to try to dumb this whole area down a little, and perhaps try to make all this look a little simpler than it actually is. Devine Millimet was kind enough to provide the specific section of New Hampshire’s statutes that I’m referring to.
What’s the problem, you wonder? Well, the New Hampshire Business Profits Tax (BPT) is a tax of 8.5% on the income of your business. So, if you made $40,000 as a sole proprietor from your dry cleaning business, you would have to pay $3,400 to New Hampshire as BPT tax. However, because we have no ‘income tax’, the state permits you a deduction against that $40,000 for ‘reasonable compensation’, resulting in NO business profits tax owed. Now, New Hampshire has enacted new rules giving specific guidance on what reasonable compensation is.
Let’s start with the safe harbor.
First, if the profit we’re talking about is due to a sale of assets, an amount not to exceed 15 percent of the gross selling price as a commission on that sale is permitted, no questions asked.
Second, A business organization or group of related business organizations may elect to deduct up to $50,000 as total compensation for the tax year, again no questions asked. This should be good for many sole proprietors, but will undoubtedly cause problems for partnerships since the safe harbor is for the entire organization, provided at least one partner or member of an LLC performed personal services for the business organization or group of related business organizations.
In an article written by Maurice Gilbert, Director of state taxation for Devine Millimet, he states “…It is clear from these statutory changes to the BPT that business organizations will be required to maintain supporting documentation for any compensation deduction taken for proprietors, partners and members of limited liability companies that is greater than the recordkeeping safe-harbor … Failure to maintain supporting documentation could result in a complete disallowance…”.
So, what are some things that Mr Gilbert suggests that the business owner could do to help build a case that their owner, member, or partner compensation is reasonable? Guidance is limited, but this might include:
- Using employment agreements that identify key services provided and the methodology for compensating the individual for such services, This could actually be a huge argument that all affected businesses in New Hampshire should be operating as an LLC or some other incorporated entity, since a sole proprietor could not enter into such an agreement.
- Retaining any personal calendars, appointment notes, comments entered on the owner-employee’s PDA devices, such as their I-Phone or Blackberry, regarding business activities or other business records that demonstrate the activities of the owner-employee. Examples of such records may be sales reports in the case of an individual who is involved in the marketing side of the contracts or other agreements requiring the skills of the owner-employee that may have been negotiated by the individual during the taxable period or other business documents that support the owner-employee’s key efforts.
- Compensation paid by a similar company to its owner-employee could establish the reasonableness of a deduction, provided you can get your hands on what that would be.
- Comparing the compensation methodology for the owner-employee and other employees of the business also provides potential support for the compensation level of the owner-employee. A business that provides, for example, significant bonuses to key employees, other than the owner, for their contributions can support the reasonableness of a compensation plan that includes significant bonuses to the owner-employee.. or
- Documented discussions with your tax preparer exploring the value of your services for the year.
Many small business owners are going to want to ignore this., but one thing to realize is that before these rules were instituted, the burden of proof was on the state. That burden has now been moved to the taxpayer, so absent ANY proof could be a real problem.
There are also a couple of other techniques that I can see being very useful in avoiding a challenge, but you’ll have to call me and we can meet to discuss those further!
Steven A Feinberg, CPA of Appletree Business Services LLC, a PASBA member accountant, located in Londonderry, New Hampshire, has more than twenty five years experience in Federal and New Hampshire issues, specializing in small business general, tax and payroll matters. For additional information on these and other current business and tax issues, email Steve at info@appletreebusiness.com or call (603) 434-2775.
Steven A. Feinberg – www.AppletreeBusiness.com – Get Appletree Blog via Email!
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