Compensation to corporate shareholders is truly not that complicated, right? After all, your business deducts the wages, and the owner reports the income on his or her tax return. End of story. Not so fast. Compensation to corporate shareholders is one of the more scrutinized audit issues because the IRS and taxpayers may have competing interests. To make matters more complicated, the determination of the “correct” amount of compensation is situationally driven and impacted by everything from business results (which makes sense to most business owners) to what type of entity is paying the compensation (which may make sense only to a tax practitioner).
The IRS has reviewed the compensation of C-corporation shareholders for years to ensure it is not unreasonably high. Why? If the owner of a C corporation takes a salary, the result is generally simple: the corporation deducts the salary and payroll taxes, and the individual pays taxes on the wages—one layer of tax. A dividend puts the cash in the shareholder’s hands without the corresponding tax deduction at the corporate level—two layers of tax. Not surprisingly, taxpayers and the IRS often argue about how high shareholder wages can go before they are “unreasonable.” What is the price tag when the IRS wins? Wages being treated as dividends, which results in double taxation, once when the corporation generates the revenue and once again when the shareholder receives the dividend.
Flip the switch to an S corporation and get opposite motivations to the same question. Profitable S corporations can generally distribute S-corporation earnings tax free; there is no dividend treatment to the extent the shareholder has reported the business income on his or her tax return. Now the IRS and taxpayers clash on wages that are too low. By lowering wages, owners and their companies reduce the liability for Social Security and Medicare taxes, resulting in one layer of tax and savings on payroll taxes, a win for the taxpayer that the IRS is heavily scrutinizing.
Is your business at risk? The answer may not be clear cut, but ask the following questions—because the IRS will if they challenge the reasonableness of owner compensation:
- What are the results of business operations and future business strategic plans
- What does ownership do to earn the wages paid (expertise, time spent, etc.)?
- How do owner salaries compare to the market (if applicable)?
- What has been paid historically to owners and why?
- Do the owners have any other cash flows from the business (rent, dividends, and distributions)? How much of each do owners have, and how is it determined?
- What role do other employees and owners play in generating business profits?
- Does your entity type incentivize an auditor to argue that ownership compensation is too high or too low?
- Are there any significant swings in compensation from year to year? Why did they occur?
- What “return on investment” are the owners receiving in cash flow other than compensation?
- Would S-corporation distributions re-characterized as wages be subject to Social Security and Medicare taxes or just Medicare tax?
- What limitations does owner compensation place on the owners’ ability to fund their retirement? (Okay, you caught me! The IRS won’t ask this, but you should. Be on the lookout for owner compensation that limits owners’ ability to fund their retirement).
Evaluate your answers to determine whether action should be taken to either adjust compensation or document the compensation rationale.
Document? Absolutely! There are often very legitimate reasons compensation that on its face appears unreasonable is, in fact, quite reasonable. Contemporaneous documentation of those facts can be helpful in successfully defending against an unreasonable-compensation attack. Board meeting minutes are a great place to start.
Let us leave you with this: There are many moving parts in determining the correct level of shareholder compensation, some of which are not addressed here. Talk to your tax professional to help you determine the correct answer for your facts and circumstances.