All corporations are required to pay their shareholder/employees a reasonable compensation. One of the challenges facing corporations is how to determine reasonable compensation for these individuals, especially since “reasonable compensation” is not defined by the Internal Revenue Code or by IRS Regulations. Complicating matters is the legal entity selected by the owners of the corporation.
If a C Corporation is chosen, the corporation tends to pay “too much” compensation to its shareholder-employee to reduce taxes paid. The motivating factor for the corporation is to drain the profits of the corporation because the corporation is subject to a federal corporate income tax that can be as high as 35%, and with state income taxes, would likely be in the 40% range. By paying the shareholder-employee a significant salary at the end of the year, the corporation drains the profits of the company avoiding the corporate income taxes. Upon audit, the IRS would likely find that a portion of the excessive compensation paid is a disguised dividend, and since dividends are not tax deductible, the corporation is subject to income tax. In addition, the shareholder-employee has dividend income to report which is taxed on Form 1040, resulting in double-taxation of the amount classified as a dividend.
If an S Corporation is chosen, the corporation tends to pay “too little” compensation to its shareholder-employee to reduce taxes paid. Since S Corporations are pass-through entities that do not pay an income tax at the corporate level, the corporation’s income flows through to the shareholder-employee’s personal income tax return and is taxed there. Since there is not a corporate income tax, double taxation is not an issue. Furthermore since income from the S Corporation is not subject to payroll taxes and only subject to personal income taxes, corporations may be prone to under compensate the shareholder-employee to avoid payroll taxes. Upon audit, the IRS would likely argue that the compensation paid was too little, and then revise the payroll filings to show the amount of compensation that should have been reported during each pay period and assess the appropriate penalty and interest assessments for failure to timely remit payroll taxes when due.
Shareholder-employees need to be proactive in establishing a reasonable compensation. While “reasonable compensation” is not defined, there are numerous court cases that can be examined to help compute reasonable compensation. The courts have looked at employee qualifications; the nature, extent and scope of the employee’s work; the size and complexity of the business; general economic conditions; comparison of salaries paid to other employees of the company; prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry; previous years’ compensation; comparison of salaries with distributions and retained earnings; and geographic factors to name a few factors.
Note: Because each industry and corporation has unique factors needs that need to be examined when determining reasonable compensation paid to shareholder-employees, we invite you to call 610-594-2601 today to make an appointment to discuss your personal situation and how best to determine reasonable compensation.
Copyright © 2013 Keystone Financial Solutions, P.C. All rights reserved. BE SURE TO READ THE DISCLAIMER PAGE: Content in this blog is for educational purposes only and should not be considered as the rendering of tax, legal or investment advice. The publisher of this blog makes no representations as to the accuracy or completeness of any information herein, will not be liable for any errors or omissions, and shall not assume liability for any losses, injuries, or damages from the display or use of this information.
