As the owner of an incorporated business, you’re likely already aware of the tax advantage associated with taking money out of a C corporation as compensation rather than as dividends. The rationale behind this is simple: a corporation can deduct salaries and bonuses paid to executives, but not its dividend payments. 

While funds paid out as compensation is only taxed once — to the employee who receives it — funds withdrawn as dividends are essentially taxed twice—once to the corporation and once to the recipient. However, there is a limit on how much money you can take out as compensation. 

Under tax law, the compensation must be considered reasonable in order to qualify as a deduction. Any unreasonable amount is not deductible, and if paid to a shareholder, may be taxed as a dividend. Furthermore, the IRS is typically much more interested in unreasonable compensation payments made to someone directly “related” to a corporation, such as a shareholder or member of a shareholder’s family. 

What is reasonable compensation?

Unfortunately, a simple formula doesn’t exist. In most cases, the IRS tries to determine a fair amount based on what similar companies  pay for comparable services under similar circumstances. Factors that are taken into account include:

• The corporation’s salary policy for all its employees.
• The employee’s skills and achievements
• The employee’s compensation history
• The duties of the employee and the amount of time it takes to perform those duties
• The complexities of the business;
• The gross and net income of the business

However, there are some concrete steps you can take to ensure the compensation you earn will be considered reasonable, 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).
• 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.
• Use the minutes of the corporation’s board of directors to contemporaneously document the reasons for compensation paid. For example, if compensation 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.)
• 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.

Remember, you can always avoid problems by planning ahead. To learn more about how Smolin can help you strike the right balance, contact us today.