The tax code mandates that employee-owners of closely held corporations, whether “C” or “S” corporations, must pay themselves a salary termed as Reasonable Compensation. For “C” corporations, which are taxed at the company level, employee-owners can receive compensation through a mix of salary and dividends. However, dividends are not deductible by the corporation and are taxable on the employee-owners’ personal tax returns, leading to double taxation. To minimize this, employee-owners of “C” corporations often aim to increase their salary and reduce dividend payouts.
Conversely, employee-owners of “S” corporations, which are taxed on personal returns like pseudo partnerships, prefer to take minimal salary and maximize distributions, as distributions are not taxable and do not incur self-employment tax. The 2018 tax reform, known as the TCJA, introduced a 20% deduction on taxable income, called the Qualified Business Income (QBI) deduction, which includes the employee-owner’s salary in its calculation.
Determining what constitutes Reasonable Compensation is crucial, as there is no specific guidance in the tax code. Courts have used nine factors to assess this, essentially boiling down to two questions: what would the employee-owner earn if working for another company in the same industry, and what would they pay someone else to do their job if they couldn’t work? The IRS requires companies to prove that their compensation is reasonable, with penalties for inaccuracies including a 20% accuracy penalty and potential reassessment of past tax returns.
The IRS guidelines emphasize that compensation amounts must be verifiable, demonstrable in origin, and entered in good faith. Personal expenses paid by the corporation must be recorded as salary, even if the corporation incurs a loss. Given the IRS’s focus on Reasonable Compensation audits, failing to comply can result in significant costs, making an independent analysis essential to ensure compliance and avoid hefty penalties.