Reasonable Compensation

The two primary ways of taking money out of a corporation is as compensation for work or as a dividend; each has different tax consequences. Salaries and bonuses are deductible by the corporation and taxable to the recipient employee, whereas dividends are not tax-deductible by the corporation and are taxable to the stockholder recipient. Thus, the dividends are taxed twice.

If you think you can avoid double taxation by only taking compensation and never paying dividends--think again! To counter that strategy, tax law includes a provision that says that compensation can be deducted only to the extent that it is reasonable. This is most frequently encountered where the employee is a shareholder or is related to a shareholder.

There is no magic formula for determining reasonable compensation. It is generally based on fact and circumstances and what is comparable for other companies in the same business. Factors that are considered when making that determination include:

• Company employee salary policy;
• Time spent to perform job duties;
• Employee's duties and responsibilities;
• Employee's abilities and accomplishments;
• Business’s complexities;
• Income of the company, both gross and net;
• Historical compensation history;

To reduce the chances of having compensation deemed as “unreasonable” by the IRS, there are some steps you can take. For example:

• Document in the corporate minutes the reasons for the level of salary or why bonuses are being paid.
• If the current year’s salary has been increased to make up for a salary that was too low in prior years, document that in the corporate minutes. Hopefully, you included notations in the prior years’ minutes stating that the compensation was at a reduced rate.
• Don’t pay salaries in direct proportion to the stock ownership. It looks too much like a disguised dividend.
• Keep your salary in line with others in the same industry. Document your research in case you are later called upon to prove it.
• Pay out at least some dividends if the business is profitable, thus avoiding the impression that the corporation is trying to pay out all of its profits as compensation.

The issue of reasonable compensation usually occurs a couple of years after the payments are made and can have effects on multiple years. Therefore, it is best to plan ahead and avoid problems later. Please give us a call if we help with this issue.