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).
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.
Barbara Weltman is an attorney, author (with such titles as J.K. Lasser’s Small Business Taxes and The Complete Idiot's Guide to Starting a Home-Based Business), and trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com, and host of Build Your Business radio. Follow her on Twitter: @BarbaraWeltman.