The IRS and closely held C corporations often disagree about the reasonableness of compensation paid to shareholder-employees. The company wants to classify payments to shareholder-employees as deductible compensation expense. But the IRS would prefer to classify some of the payments as nondeductible dividends. Here's what C corporations should consider when addressing the treatment of payments to shareholder-employees for federal income tax purposes.
The Internal Revenue Code allows a business to deduct a "reasonable allowance for salaries or other compensation" it pays to executives and other employees. Compensation can include:
The IRS typically focuses on salary and bonuses, often ignoring other forms of compensation unless they're highly excessive.
When an executive or employee is also a shareholder of the C corporation, his or her compensation shouldn't exceed what similar companies typically pay for comparable services. The IRS may challenge shareholder-employee compensation it believes is unreasonably high, arguing that the excess constitutes a disguised dividend.
When the IRS reclassifies excess compensation as dividends, the payments will be subject to two levels of tax. First, the corporation loses out on the compensation deductions and must pay corporate income tax on those earnings. Second, recipient shareholder-employees are taxed on amounts treated as dividends. Taxable dividend treatment occurs to the extent the corporation has accumulated earnings and profits (similar to retained earnings).
The Tax Cuts and Jobs Act (TCJA) reduced the federal income tax rate on C corporations to a flat 21%. However, double taxation remains undesirable and should be avoided whenever possible.
You can't necessarily avoid double taxation by leaving funds inside your C corporation instead of making payments that will constitute taxable dividends to shareholder-employees. Why not? First, most shareholders want to get cash out of their companies. Second, failure to distribute dividends can expose the corporation to the accumulated earnings tax (AET). This is essentially a federal penalty tax on retained corporate earnings and profits, beyond what's deemed to be needed for corporate business purposes. The following amounts of retained earnings and profits are automatically AET-exempt:
When the IRS assesses the AET, the rate is the same as the maximum federal income rate individual taxpayers owe on dividends (20%). However, the rate could increase if Congress increases tax rates on dividends.
Generally, the best way to avoid double taxation of dividends and the AET is to maximize deductible compensation provided to shareholder-employees. This includes salaries, bonuses and fringe benefits. Maximizing deductible compensation expense minimizes the corporation's annual taxable income. However, there's a catch: The compensation payments must be reasonable. That determination can be subjective, so it's essential to assess your situation carefully in light of IRS guidance.
C corporations should be prepared to support their deductions for compensation paid to shareholder-employees. But reasonableness is in the eye of the beholder, and there are no bright-line rules. In many cases, the founders of a closely held C corporation have made significant personal sacrifices, taken on multiple roles, and served as the driving force behind the company's success over the years. During times when cash was tight, they might have been grossly underpaid.
Here's a checklist of factors, grounded in IRS guidelines and relevant legal precedent, to assess whether your shareholder-employee compensation deduction meets the test of reasonableness:
When using this checklist, affirmative answers indicate that reasonable compensation is likely, while negative answers suggest the opposite. However, having some "No" responses won't automatically result in IRS scrutiny. Determining reasonable compensation is more art than science, and each factor's importance depends on situational facts.
Contact your tax advisor for additional guidance on reasonable compensation. With proper planning and documentation, you can manage this issue with confidence.
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