Corporate Business Owners Must Have “Reasonable Compensation”

• Learn about the tax advantage of taking money out of a C corporation as a salary rather than a dividend.
• What happens if the IRS deems a salary unreasonable?
• Find out how to determine reasonable compensation.

Owners of incorporated businesses know that there’s a tax advantage to taking money out of a C corporation as compensation rather than as dividends. The reason is: A corporation can deduct the salaries and bonuses that it pays executives, but not dividend payments. Thus, if funds are paid as dividends, they’re taxed 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. But rules exist for what we call “reasonable compensation” (and Fiducial has those rules for you below!).

However, there are limits to how much money you can take out of the corporation this way. Under tax law, compensation can be deducted only to the extent that it’s reasonable. Any unreasonable portion isn’t deductible and, if paid to a shareholder, may be taxed as if it were a dividend. Keep in mind that the IRS is generally more interested in unreasonable compensation payments made to someone “related” to a corporation, such as a shareholder-employee or a member of a shareholder’s family.

Determining reasonable compensation

There’s no easy way to determine reasonable compensation. In an audit, the IRS examines the amount that similar companies would pay for comparable services under similar circumstances. Factors that are taken into account include the employee’s duties and the amount of time spent on those duties, as well as 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 some steps you can take to make it more likely that the compensation you earn will be considered as reasonable compensation, and therefore deductible by your corporation. For example, you can:

• 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, contemporaneously document the reasons for compensation paid. For example, if the corporation increases compensation in the current year to make up for lower-paying earlier years, make 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 for the services being performed. Be sure to detail the services performed.) Cite any executive compensation or industry studies that back up your compensation amounts.
• Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This looks too much like a disguised dividend and the IRS will probably treat it as such.
• If the business is profitable, pay at least some dividends. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.

What’s next?

You can avoid problems and challenges by planning ahead. Have questions or concerns about your situation? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.

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