- Learn about the difference in tax treatment between dividends and compensation.
- Find 4 steps to help you determine (and document) reasonable compensation.
If you’re the owner of an incorporated business, you know there’s a tax advantage to taking money out of a C corporation as compensation rather than as dividends. The reason: A corporation can deduct the salaries and bonuses that it pays executives, but not dividend payments. Therefore, if you receive payments as dividends, taxation occurs twice, once to the corporation and once to the recipient. Money paid out as compensation is only taxed once — to the employee who receives it. However, there are limits to how much money you can take out of the corporation this way. Under tax law, you can only deduct reasonable compensation.
You cannot deduct any “unreasonable” portion, and, if paid to a shareholder, this portion may be taxed as if it were a dividend. Remember that unreasonable compensation payments made to someone “related” to a corporation, such as a shareholder-employee or a member of a shareholder’s family, hold more interest for the IRS. The issue moves in a different direction concerning S corporation shareholders. There is no "double taxation" issue with an S corporation and the general desire is to reduce compensation and increase pass-through income as payroll tax applies to compensation and does not to S corporation distributions. Therefore, the key to S corporation shareholders is to make sure to pay a reasonable salary. This is especially important if any distributions, rent, or loan repayments are being made to the shareholder.
Steps to determine reasonable compensation
There’s no simple way to determine reasonable compensation. If the IRS audits your tax return, it will examine the amount that similar companies would pay for comparable services under similar circumstances. Factors taken into account include the employee’s duties, the amount of time spent on those duties, and the employee’s skills, expertise, and compensation history. Other factors that may be reviewed are the complexities of the business and its gross and net income.
There are four steps you can take to make it more likely that the compensation you earn will be considered “reasonable,” and therefore deductible by your corporation:
- Keep compensation in line with what similar businesses are paying their executives (and keep whatever evidence you can get of what others are paying to support what you pay).
- In the minutes of your corporation’s board of directors’ meetings, contemporaneously document the reasons for compensation paid. For example, if payment is being increased in the current year to make up for earlier years in which it was low, be sure that the minutes reflect this. (Ideally, the minutes for the earlier years should reflect that the compensation paid then was at a reduced rate.) Cite any executive compensation or industry studies that back up your compensation amounts. Another example would be if an S corporation shareholder-employee reduces compensation, make sure the minutes reflect the reason, such as reduced hours.
- Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This looks too much like a disguised dividend and will probably be treated as such by the IRS.
- If the business is profitable, pay at least some dividends, and for an S corporation if cash flow permits, take distributions. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation or, about an S corporation, establishes a history of making distributions.
You can avoid problems and challenges by planning. Have questions or concerns about your situation? Call Fiducial at 1-866-FIDUCIAL or make an appointment to discuss your situation at one of our office locations.