Preface: Proper planning can maximize the amount of compensation a company can pay in a way that will increase its chances of being able to withstand an IRS challenge.
Taking High Compensation Without Dividend Danger
Owners of a closely held C corporation know that the company’s earnings are theoretically exposed to a double tax. Principlly, earnings are first taxed to the corporation and those that are distributed to as dividends are taxed on your individual income tax return, without the company getting a deduction for the payments.
On the other hand, the company can deduct the salary it pays you. While you have to pay tax on the salary, unlike dividends, salary is taxed only once. And while dividend income is taxed at net capital gains rates (at a maximum 20 percent rate if all income exceeds a $470,700 threshold for joint filers, $418,400 for single individuals in 2017), that is an additional 15 or 20 percent that you may not otherwise have to pay with proper compensation planning. What’s more, investment income is also subject to the 3.8 percent Net Investment Income (NII) surtax if an individual’s overall income exceeds a $250,000/$200,000 level.
Does this mean that the double tax can be avoided simply by increasing your salary rather than by paying dividends? No, there are two potential problems with that approach. First, the company can only deduct reasonable compensation. Second, if compensation is set at the high end of the scale and is later found to be unreasonable, the IRS can charge the owner with a constructive dividend on the unreasonable portion of the compensation.
What then can be done? Proper planning can maximize the amount of compensation the company can pay in a way that will increase its chances of being able to withstand an IRS challenge.
The basic test of reasonableness, as applied by the IRS and many courts, is whether the amount paid is analogous to that paid by employers in like businesses to equally qualified employees for similar services. In this respect, the total compensation package is examined including contributions to retirement plans and other employee benefits.
As a result, a showing of special skills may help to justify reasonableness. It also can be helpful if the individual performs different roles for the company (for example, chief executive officer and designer of a new product).
Another possible approach may be to set up a portion of an owner’s compensation to be paid as bonuses if profits meet certain levels. While the IRS has attacked such contingent compensation arrangements in family companies, some courts have upheld them where the agreement was set up when the business was started or when the amount of the future earnings was questionable, and the agreement was consistently followed during the ups and downs of the business.
Few businesses start out with the owners able or willing to pay themselves what they are really worth. Even after the business is successful, periods of economic slowdown, may force belt tightening. It is in these situations that an owner may have an opportunity to enter into a formal contract with the company calling for a share of the profits as added compensation when things improve.
If this is done it’s important to include in the corporate minutes the record showing that the owner was underpaid at the time the agreement was entered into. The minutes also should show that the contingent payment out of future profits is merely intended to provide an incentive for the owner to put forth his best efforts to build the business and to make up for the periods of underpayment.
Attenton to such details when planning compensation arrangements should help owners fend off or blunt future attacks on compensation when the business proves highly successful and substantial compensation is paid under the agreement.
This blog is not tax advice, but simply education on appropriate IRS rules and regulations.