As the owner of an incorporated business, you’re probably aware there is 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 it pays, but not dividend payments. Thus, if funds are withdrawn as dividends, they are taxed twice; once to the corporation and once to the recipient. Money paid out as compensation is taxed only once; to the employee in which it was received.
However, there is a limit on how much money you can take out of the corporation in this way. The law says compensation can be deducted only to the extent which is 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 is no simple formula. The IRS attempts to determine an amount similar companies would pay for comparable services under like circumstances. Factors taken into consideration include:
- employee’s duties;
- amount of time required to perform those duties;
- employee’s abilities and accomplishments;
- complexity of the business
- gross and net income of the business;
- employee’s compensation history
There are a several steps you can take to make your compensation earned to be considered “reasonable”. For example, you can:
- Use the minutes of the corporation’s board of directors to document the reasons for the amount of compensation paid
- Keep compensation in line with what similar businesses are paying their executives
- Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This is may be perceived as a disguised dividend, and will probably be treated as such by the IRS.
- 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.
Planning ahead and properly documenting your reasons can avoid problems down the road.
By: Jenny Furey, CPA