Shareholder-Employee Compensation: Find the Right Balance

The IRS may object to the compensation of C corporation shareholder-employees. If it’s deemed too high — or not “reasonable” under the circumstances — the IRS could force you to make adjustments that increase taxes.

This can be particularly troublesome for C corporation owners and executives who are also shareholders, because they’ll then be hit with double taxation.

When double taxation comes into play

When a 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 dividends, the money is taxed twice — once at the corporate level and again at the personal level. Plus, the business can’t deduct dividend payments.

But compensation must be reasonable. If the IRS considers it too high, it can label part of the payments as “disguised dividends,” which are taxed twice. There could also be back taxes and penalties.

What’s considered reasonable?

There’s no simple formula for determining a reasonable salary. The IRS will look at the amounts that similar corporations pay their executives for comparable services. Some of the other factors it considers are the employee’s duties, experience, expertise and hours worked.

Not surprisingly, the issue of reasonable compensation frequently winds up in court. To protect yourself, 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 the compensation is reasonable.

If your business is profitable, you should generally pay at least some dividends. By doing so, you avoid the impression that the corporation is trying to pay out all profits as compensation. We can help determine whether dividends should be paid and, if so, how much they should be.