How to avoid tax pitfalls?

Excessive Salary for Shareholder-Employees:

Are You at Risk?

Are you a shareholder-employee of your own company? You may have heard of the concept of an "excessive salary." But do you really understand what it means for your taxes?

The principle of an "excessive salary" is a notion introduced by the tax authorities to prevent a company's taxable net profit (Articles 57 and 58 of the Federal Act on Direct Federal Taxation - LIFD) from being reduced by expenses that are not justified by commercial use (Article 59 LIFD). In this effort to preserve economic double taxation, the tax authorities reclassify distributions of profit, whether open or concealed, just as they would unjustified benefits provided to shareholders or their close associates that are not commercially justified.

The question is whether someone who is both an employee and a shareholder (or closely related to one) of their own company is awarding themselves a commercially justified salary according to market standards (arm's length principle), in a context where their dual role might be problematic.

What the Tax Authorities monitor

The concept of an "excessive salary" is straightforward: the tax authorities ensure that your salary is justified by commercial usage. If they deem your salary too high compared to the real value of your work, they may reclassify it as a concealed profit distribution. The risk? An increase in your company's taxable profit, with all the consequences that entails.

An excessive salary is simply a concealed distribution of profit as defined by Articles 20, paragraph 1, letter c, and 58, paragraph 1, letter b of the LIFD. It represents an expense that is not justified by commercial use and is therefore added to the taxable net profit. Four conditions must be met for the shareholder-employee's salary to be considered as unduly reducing economic double taxation and thus reclassified:

Absence of a corresponding consideration impoverishing the company.
Remuneration of the shareholder (or a closely related person).
The remuneration would not have been granted under such conditions to a third party.
A manifest disproportion between the service and the counter-service, such that the company’s directors should have recognized the advantage given.

The "Valaisan" method: a strict evaluation

To determine whether a salary is excessive, the authorities often use the "Valais method." This method relies on specific criteria such as education level, experience, and company performance. But are you confident your remuneration would pass this test?

The analysis of a shareholder-employee's excessive salary is primarily economic, requiring interpretation as such. In the absence of a detailed, costly, and difficult market study, the cantonal tax authorities base their analysis on the so-called "Valais method," leaving the taxpayer to provide a more complete and appropriate analysis if they find it in their interest to do so.

Endorsed by the Federal Tax Administration (AFC) and the Federal Supreme Court (TF), the method is considered non-arbitrary and adapted to the specific circumstances of each case, but its rigidity, unsuited to more complex cases, can be overturned, as we shall see below.

The method first determines an average base salary based on statistics that take into account the position held, experience, and education. This base salary is then increased by a percentage of the company's turnover (1% up to CHF 1 million, 0.9% up to CHF 5 million, and 0.8% beyond that; noting that the participation is doubled for service companies to account for the high gross margin of such firms). Finally, a variable consisting of a share of the profit is added; this share is 1/3 for companies with fewer than 20 employees and 1/4 for larger companies.

Why should you be concerned ?

Even though the tax authorities do not systematically check every salary, certain situations may trigger an audit, such as a financially difficult year for your company. In such cases, you may find yourself having to justify a salary deemed excessive, with potentially serious consequences if it is reclassified.

Based on the above, the cantonal tax authorities can reclassify the salary in question. Four types of taxes are impacted by the fiscal consequences that result from this adjustment:

Corporate income tax: The company's taxable profit is increased by the amount of the concealed distribution (i.e., the portion of the salary deemed excessive).
Personal income tax: Aside from a possible withholding tax issue, there is no significant difference. It should be noted that Circular AFC No. 22 (2020, section 2.2.3, p. 3) allows partial taxation (70%) of dividends from qualified participation (10%) if the distributing company has been subject to a profit adjustment.
Withholding tax: Due to the probable absence of a 35% withholding on the concealed dividend distribution, the tax authorities may retroactively demand payment of this tax. The taxpayer can recover this tax according to the usual procedure and conditions outlined by the Federal Act on Withholding Tax and the Ordinance on Withholding Tax.
Social security contributions: The AHV (social security) paid on the excess salary can be reclaimed within one year after the tax decision becomes final (Article 16, paragraph 3, in fine, of the AHVG).

What can you do?

It is essential to anticipate and prepare a solid justification for your salary policy. Factors like salaries paid for similar positions in the industry can help you prove that your remuneration is legitimate. But is that enough?

The salary policy for a shareholder-employee should therefore be subject to thorough economic justification, presenting various arguments such as the remuneration of individuals in similar positions or functions, salaries paid by other companies in the same industry, including a former employer, as well as other factors related to the company's characteristics and those of the shareholder-employee, thus also leaving room for putting the company's results over the years into perspective.

What about you, is your salary safe?

The reclassification of a shareholder-employee’s salary can be unsettling for other shareholders, administratively burdensome, and subject to serious tax consequences if nothing is done. The Valais method is the starting point for the tax authorities to provoke a more in-depth analysis and determine whether a salary is defensible.

Why taking that risk? Our expertise is here to help you navigate this fiscal maze. Contact us for a personalized advice and find out how we can help you secure your tax situation.