How Much Should You Pay Yourself?

If your business is incorporated, you can take a salary for the work that you do. Obviously, your company’s revenues are a big part of the decision on how much you can afford to take out of its coffers as compensation. Taxes are another important factor.

C or S?

Which type of corporation you run affects the decision on compensation. As a general rule (and by no means your guiding factor):

• C corporations want to optimize compensation to an owner to create as large a tax deduction as possible.
• S corporations want to minimize compensation to keep employment taxes low. Owners will pay income tax one way or the other (as their share of profits or as compensation).

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IRS looking over your shoulder

The IRS is well aware of the general rules for C and S corporations. Thus, it seeks to disallow a C corporation’s deduction for any compensation that is not considered to be “reasonable” under the facts and circumstances of the situation.

By the same token, it is on the hunt for S corporations and their shareholders who try to avoid employment taxes by underpaying compensation. One recent court decision is a case in point. A CPA was the sole owner, shareholder, director, and employee of his S corporation. He had a contract with his corporation to provide exclusive services and took a salary of $24,000 each year (for the years in question). He also had dividends distributed to him of $203,651 and $175,470 in these years. The IRS recharacterized the dividends as compensation and imposed FICA taxes on them. A district court, affirmed by an appellate court, said that the economic realities of the situation—the earnings of the corporation based on the owner-employee’s services—should control the amount of compensation. (The IRS’ expert witness was used to determine what was appropriate compensation in this situation.) Thus, paying a minimum salary may not be sufficient to avoid an IRS challenge if the minimum amount is not reasonable under the circumstances.

Work with a tax advisor

Compensation to owner-employees typically is fixed in the annual meeting for the corporation and memorialized in the corporate minutes. It is a good idea to discuss the compensation matter with a tax advisor before holding the annual meeting and setting compensation for the coming year.