October, 2010 Tax Tip
Reasonable Compensation – Part 1
If you own a corporation, you're probably aware that there's a tax advantage to taking money out of the corporation as compensation (salary and bonus), rather than as dividends. The reason is that a corporation can deduct the compensation that it pays, but not its dividend payments. Thus, if funds are withdrawn as dividends, they're taxed twice, once to the corporation (when it was received) and again to the recipient shareholder. Money paid out as compensation is taxed only once, to the recipient.
However, there's a limit on how much money can be taken out of the corporation in this way. Tax law says that compensation can be deducted only to the extent that it's reasonable. Any unreasonable portion is nondeductible and, if paid to a shareholder, may be taxed as if it were a dividend. As a practical matter, IRS rarely raises the issue of unreasonable compensation unless the payments are made to someone “related” to the corporation, such as a shareholder or a member of a shareholder's family. Therefore, it’s not an issue with a publicly owned corporation.
How much compensation is “reasonable”? There's no simple formula. IRS tries to determine the amount that similar companies would pay for comparable services under like circumstances. Factors that are taken into account include:
· the employee's duties;
· the amount of time required to perform those duties;
· the employee's ability and accomplishments;
· the complexities of the business;
· the gross and net income of the business;
· the employee's compensation history; and
· the corporation's salary policy for all its employees.
There are a number of concrete steps that can be taken to make it more likely that the compensation you earn will be considered “reasonable” and, therefore, deductible by the corporation. For example:
§ Use the minutes of the corporation's board of directors to contemporaneously document the reasons for the amount of compensation paid. For example, if compensation is being increased in the current year to make up for earlier years in which it was too low, the minutes should reflect this. (Ideally, the minutes for the earlier years should reflect that the compensation paid in those years was at a reduced rate due, for example, to the growth needs of the company.
§ 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 IRS.
§ Keep compensation in line with what similar businesses are paying their executives (and keep whatever evidence you can get of what others are paying—e.g., salary offers to your executives from comparable companies—to support what you pay if you are later questioned).
§ If the business is profitable, be sure to pay at least some dividends. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.
Note: Stay tuned for Part 2 - The foregoing is primarily directed at the owners of C corporations. Owners of S corporations face an entirely different IRS challenge. Whereas the issue with C corporations is the payment of unreasonably large compensation to shareholders to avoid double taxation, the issue with S corporations is either paying no compensation or unreasonably low compensation to its shareholders to avoid payroll taxes. This has been the subject of significant IRS attention in the past couple of years, and I will discuss it in an upcoming Tax Tip.
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