CORPORATION - REASONABLE COMPENSATION (Federal level - authority omitted)
Dear Client:
As the owner of an incorporated business, 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
simple. 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 Thus, if funds are withdrawn as dividends,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 and once to the recipient.
Money paid out as compensation is taxed only once, to the employee who
receives it. However, there's a limit on how much money you can take
out of the corporation in this way. The 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. 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 you can take to make it more likely
that the compensation you earn will be considered “reasonable,” and
therefore deductible by your corporation. For example, you can 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, be sure that the minutes reflect
this. (Ideally, the minutes for the earlier years should reflect that
the compensation paid in those years was at a reduced rate.) 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.
As in most tax situations, planning ahead avoids problems later. Feel
free to call me if you would like to discuss this or any other aspect of
your current or deferred compensation strategies. I look forward to
hearing from you.
Very truly yours, TaxCaffe
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