Reasonable Compensation for Shareholders of Corporations

C Corporation

• The rule of thumb for a C corporation is that one would prefer compensation of shareholders to be as high as possible but still be in line with industry standards for the size of the entity, as well as the duties performed by the shareholder/employees.
• Compensation is fully deductible, if reasonable, and will help to reduce the taxable income of the C corporation, with its potentially high tax rates.
• It is important to keep the compensation to a reasonable level; otherwise, the IRS could disallow the deduction and reclassify it as a dividend. In that case, the dividend amount would be nondeductible against the C corporation’s taxable income, and the shareholder/employee would be required to report the dividend as taxable income on their tax return.   

S Corporations

• Also need to pay their shareholder/employees a reasonable salary. However, unlike the case of C corporations, the goal for these entities focuses on paying a salary that is just high enough to avoid being characterized as being unreasonably low.
• The reason for this is the potential FICA and/or Medicare tax savings that is possible when paying a lower salary, coupled with the distribution of S corporation earnings. The latter, which is not taxable as compensation, allows an S corporation shareholder to withdraw cash from their business without incurring the payroll taxes that would be required for the payment of salaries. The IRS generally prefers that compensation be in the form of wages, because wages are subject to employment tax.

A key factor in determining whether compensation is “reasonable compensation” is if an unrelated employer would pay a comparable amount to the employee in question under the same circumstances. The bottom line for S corporation shareholders is not to get greedy and take too low of a salary in conjunction with taking too high of an S corporation distribution.

In a recent court case, (Midwest Eye Center, S.C. v. Commissioner, TC Memo 2015-53) the IRS disallowed half of a $2,000,000 bonus paid to a 100% shareholder of a C corporation. The IRS claimed that half of the bonus was a disguised dividend, rather than bonus compensation. The sole shareholder was one of the practicing doctors within the entity and also acted as CEO, COO and CFO. The burden of proof as to whether the compensation was reasonable fell upon with the taxpayer, and, unfortunately, was unprepared to support their argument, resulting in nearly $400,000 of delinquent taxes and penalties.

As this case illustrates, it is important to be able to support any deduction claimed on a tax return.  Then, if the IRS ever comes knocking on your door, you will be prepared and have everything documented.

In a highly subjective area, such as reasonable compensation, it is important to have internal documentation supporting the position that the compensation a shareholder has received is reasonable, based on the services they have provided to the entity. This can easily be documented by an entry in a corporation’s annual minutes. If compensation during the earlier startup years was low with the anticipation of a higher compensation in years to follow, then document this fact. If any large bonuses are to be paid out at year end, be sure to have adequate proof as to why the shareholder earned the bonus. 

The Zinner team of financial and business advisors can help prepare you and your business structure for optimum performance. I'm ready to help; contact me at 216-831-0733 or rhuszai@zinnerco.com for a no cost, no obligation consultation. 

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