With Facts and
The IRS may object to the
compensation of shareholder-employees of
a corporation. If the compensation is deemed too
high or too low — in other words, it is not “reasonable” under
the circumstances — the IRS could force you to make
adjustments that increase taxes. This can be particularly
Corporations must justify their
salaries based on factors such as the expertise of a
shareholder-employee, the size of the firm and
Salary versus Dividends:
Today — and Tomorrow
the past, C corporation owners often arranged to be paid
relatively high compensation amounts in order to
increase business deductions instead of paying out
nondeductible dividends. That's because dividends used
to be taxed at regular income tax rates. However,
qualified dividends are currently taxed at the same
favorable federal rates as long-term capital gains (the
maximum rate is only 15 percent). As a result, high
salaries are not necessarily preferred today.
there is a "sunset provision" in the tax law.
Unless Congress takes further action, dividends received
after 2008 will once again be taxed at regular income
tax rates, instead of the favorable capital gains rates.
may someday again prefer salary payments over
- S corporation owners who
arrange to receive little compensation, or no compensation
at all, to reduce payroll taxes.
- C corporation owners and executives who are also
shareholders and receive salaries the IRS considers too
large because they will then be hit with double taxation.
Why? Compensation is fully deductible if it's
considered "reasonable." But if a salary is deemed too
large, Uncle Sam can label part of the payments as
"disguised dividends," which are taxed twice.
Double taxation comes into play because when the
corporation distributes profits as salaries, the firm gets a
deduction for the amount. The owner or executive pays personal
income tax on the money, of course, but it's only taxed once.
But if the corporation pays the owner or executive a dividend,
the money is taxed twice — once at the corporate level and
again at the personal level.
Not surprisingly, the issue of reasonable compensation is
frequently contested in the courts. Here are two examples:
The shareholder-employee of a family-owned corporation
served as its president. The three other officers of the
corporation were the president's sons. According to court
documents, she voted on major corporate decisions for the
waste pickup and disposal business and performed other duties,
such as attending civic functions as a company representative.
Nevertheless, the IRS argued that she functioned more like an
outside board chairperson, rather than a chief executive, and
was unreasonably overcompensated.
The Tax Court
determined that her salary for the three years in question
should be $98,000, $101,000 and $106,000 rather than the
amounts deducted by the corporation ($860,680, $818,060 and
$600,060 respectively). The company appealed the
The Ninth Circuit Court focused on the
following factors to determine a reasonable amount of
compensation for the owner-employee:
- The employee’s role in the company.
- A comparison of the compensation paid to the
employee with the amounts typically paid to employees of
other companies in similar situations.
- The character and condition of the company.
- Whether a conflict of interest exists that might allow
the company to disguise dividends as deductible
- Whether compensation was paid under a structured, formal
and consistent plan.
Based on these five factors, the Appeals Court concluded
compensation should be adjusted to reflect her performance as
president of the company. It sent the case back to the Tax
Court for "redetermination of reasonable compensation."
(E.J. Harrison & Sons, CA-9, 6/7/05)
documenting the reasons for corporate salaries, you may be
able to fend off the IRS. In one Tax Court case, for example,
a business gained some leeway because it paid a windfall
amount to make up for salary shortfalls in the past.
the case, a father and son were the owners and principal
employees of a mechanical contracting business. For the year
in question, the father was paid a salary of $260,000, plus
standard fringe benefits. The IRS said that $65,000 of this
salary represented unreasonable compensation.
looking at several factors, including the fact that the father
had been underpaid in prior years in order to build up the
company’s cash reserve, the Tax Court determined that the
entire compensation amount was reasonable. (Devine
Brothers, Inc., TC Memo 2003-15)
Advice: Spell out the reasons
for compensation amounts in your corporate minutes. The
minutes should be reviewed by a tax professional before
being finalized. Cite any executive compensation or industry
studies, as well as other reasons why compensation is
reasonable. Work with your tax adviser to determine whether
dividends should be paid (and if so, how much they should
Advice: Limited Liability
Companies, because they are generally treated
as tax "pass-through" entities, avoid this audit