Let’s Be Reasonable (With Our Compensation)
June 10, 2019
One of the outcomes of the Tax Reform Act of 2017 is that some businesses are converting to C corporations and net new businesses are considering C Corporation status. Why the change? Businesses can in turn take advantage of the 21% corporate tax rate, as well as the ability to deduct state level business income taxes. Whether that is the right strategy or not is beyond the scope of this article, but we wanted to draw your attention to one of the issues companies face when they operate as a privately-held C corporation.
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 Thus, if funds are withdrawn as dividends, they’re taxed twice, once to the corporation and once to the recipient.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, the 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. The IRS tries to determine the amount that similar companies would pay for comparable services under like circumstances. Factors that are considered include the:
- Employee’s duties
- Amount of time required to perform those duties
- Employee’s ability and accomplishments
- Complexities of the business
- Gross and net income of the business
- Employee’s compensation history
- 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 the 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-such as salary offers to your executives from comparable companies-to support what you pay if you’re later questioned).
- If the business is profitable, consider paying at least some dividends. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.
- The “hypothetical independent investor test” has been spawned by a litany of Tax Court cases over the last 25 years. A Google search will reflect taxpayer-friendly cases such as Eliotts, Multi-Pak, H.W. Johnson, and many more.
An interesting sidebar is that this same reasonableness standard must be met by S corporations as well. A lower salary in a S Corporation can help reduce payroll taxes. But minimum standards need to be met. With the advent of Section 199A and the qualified business income (QBI) deduction, there can be instances where one is trying to maximize the benefit of this deduction where either a higher salary will be best, or a lower salary will win the day. As always, the devil is in the details and those details need to be documented.