As many incorporated business owners know, corporations can deduct salaries and bonuses paid to executives, but not dividend payments. Because of this, funds paid as dividends are taxed twice, both to the corporation and to the recipient, while money paid out as compensation is only taxed to the employee receiving the compensation. As such, it’s advantageous to take money out of a C corporation as compensation rather than as dividends.
There are limits, however, to how much can be taken out of the corporation under this strategy. Current tax law holds that compensation can only be deducted to the extent that the compensation is reasonable. Any unreasonable portion can’t be deducted and may be taxed as if it were a dividend if paid to a shareholder.
It’s worth noting that the IRS is typically more interested in unreasonable compensation payments if they’re made to someone who is “related” to a corporation, including members of a shareholder’s family or shareholder-employees.
How to ensure compensation is deemed “reasonable”
There’s no simple formula for determining what compensation is reasonable. During an audit, the IRS will consider how much similar companies would pay under similar circumstances for comparable services. They will also consider other factors including:
- The employee’s skills, expertise, and compensation history
- The employee’s duties
- The amount of time spent on those duties
- The complexities of the business
- The business’s gross and net income
If you want to make it more likely that the IRS will consider the compensation you earn to be “reasonable”—and therefore deductible by your corporation—there are certain steps you can take:
- Make sure that compensation is in line with what similar businesses pay their executives, and hold on to any evidence you find that supports what you pay.
- Keep contemporaneous documentation of the reasons for compensation paid in the minutes of your corporation’s board of directors. If, for example, the company has increased compensation this year to make up for lower compensation in earlier years, you’ll want the minutes to corroborate this. Ideally, you’ll also want the minutes for those earlier years to reflect that compensation was being paid at a reduced rate. Any industry studies or executive compensation that back up your compensation amounts should be cited.
- Pay at least some dividends if the business is profitable. This will keep the IRS from suspecting that your corporation is attempting to pay out all of its profits as compensation.
- Try not to pay compensation in direct proportion to the corporation’s shareholders’ stock. This will look like a disguised dividend to the IRS and will likely be treated as such.
Planning ahead can help you avoid many challenges and complications. Contact us today if you have questions or need assistance.