Hello and thank you for your question.
We can start with the issue as framed by the IRS:
"The issue of unreasonable compensation is frequently found in the
compensation of employee-shareholders and relatives employed by
closely held corporations. Shareholder-employees often attempt to
disguise corporate distributions as salary so that the corporation may
obtain a salary expense deduction that would not otherwise be
allowable if the distribution were a dividend.
"IRC section 162(a)(1) allows a deduction for a reasonable allowance
for salaries or other compensation for personal services actually
rendered. Reasonableness is determined by the facts and circumstances
of each particular case."
That's true for both C and S corporations, since both deduct
compensation under section 162.
Your question relates to the differing tax treatment of C and S
corporations. Here's a useful article on choice of entity that
touches on that issue.
Choice of Business Entity After the 2003 Tax Act
The significant difference between C and S corporations on this issue
is that C corporations pay corporate income tax on their taxable
income. The section 162 deduction reduces C corporation taxable
income and hence lowers the corporation's tax. Excessive/unreasonable
compensation is not deductible because it is recharacterized as a
dividend, which a C corporation cannot deduct. So corporate tax
increases, and meanwhile the recipient of the excessive comp,
presumably also a shareholder of the corporation, must still pay
income tax as the recipient of a divident. In other words, the excess
amount is subject to double tax.
The maximum federal corporate income tax rate is 35%
and the individual federal tax on the dividend, assuming it is a
'qualified dividend' is 15%, which compared the dividend tax under
prior law is not such a bad deal.
"A planning tip for closely held corporations suggests they reconsider
their pay packages to include more dividends in lieu of salary or
bonus. Investors might change their asset allocations to give greater
weight to dividend-paying stocks."
On the S corp side, the mechanics are the same - - excess compensation
treated as a dividend, but the tax economics are different. The
taxable income of the S corp--again, reduced by reasonable
compensation deductible under section 162--is taxed to the shareholder
ends up taxed to the shareholder anyway.
"Use of an S corporation also tended to reduce the problems associated
with unreasonable compensation. If the earnings of the S corporation
were taxed as salary to the officer shareholder, they were not taxed
as a distribution. The IRS obtained its "fair share" in either case.
The question of inadequate compensation may have been raised for an S
corporation in situations where salaries were being paid to several
family members?some of whom were in lower tax brackets?with the effect
that a disproportionately low salary was being paid to those
contributing most to the profitability of the S corporation."
Finally, there are the social security and medicare tax
considerations, which also (like the 15% qualified dividend rate for a
C corporation and the flow-through of corporate taxable income in an S
corporation) make it less painful, and even potentially beneficial to
the taxpayer, to accept the IRS argument and pay smaller compensation
amounts and larger dividends.
So that nowadays, the IRS and the taxpayer may take positions opposite
to what they would have in years past, so that now the IRS may argue
that compensation is unreasonably low(!) and thereby try to
recharacterize corporate dividends as additional compensation.
"Compensation received by stockholder/employees is subject to
employment taxes. The shareholder's distributive share of the
corporation's income, whether distributed or not, is not subject to
these taxes. Consequently, this change in the Medicare tax creates an
additional motive for the IRS to claim that compensation is
unreasonably low and to attempt to recharacterize distributions or
undistributed income as compensation.
"Inadequate Compensation Treated as Unreasonable
An alternative is to recharacterize earnings distributions from an S
corporation as disguised payments of compensation to the shareholders.
In Rev. Rul. 74-44 the "dividends" paid to two shareholders were held
to be in lieu of reasonable compensation for their services. The
shareholders drew no salary from the corporation but arranged for the
corporation to pay them "dividends," which happened to be the exact
amount due them for the services rendered to the corporation. The
ruling states that such compensation represented "wages," and
liability was incurred for FICA withholding, Federal unemployment
taxes and withholding of Federal income taxes. In the example
discussed in the ruling, the intent to avoid payment of employment tax
was apparent. The intent was to compensate the shareholders for
services, and the amounts received were reclassified as wages.
The issue of inadequate compensation has been litigated. In Joseph
Radke, 712 F. Supp. 143 (E.D. Wis. 1989), aff'd per curiam, 895 F.2nd
1196 (7th Cir. 1990), the court upheld the IRS's assessment of payroll
taxes on the taxpayer's deemed salary. In Radke, the sole
shareholder/employee was an attorney who incorporated his practice and
continued to take monies out on an as needed basis when the
corporation had cash. The court held that not all corporate income may
be reclassified as wages, but that payments made for remuneration of
services performed clearly fell within the statutory and regulatory
definition of wages. The Seventh Circuit determined that regardless of
how an employer chooses to characterize payments made to its
employees, the true analysis is whether the payments are for
remuneration for services rendered."
The above is a 1995 article, which is why it is limiting the situation to S corps.
So to conclude with the tax strategies for these groups, the simplest
case is an S corp owned 100% by one individual or by husband and wife.
Lower compensation means lower Medicare tax, a 2.9% tax savings, and
significant social security tax savings to the extent compensation can
be lowered below the social security tax taxable wage base ($ 90,000).
If there are other shareholders who are family members in lower tax
brackets, that offers additional savings.
The strategy is the same for a C corp, except that there will be
corporate tax (up to 35%) and individual tax (15%) on the dividend
portion, which may wipe out the savings. So the IRS may still prefer
to argue in favor of the dividend (i.e. that compensation has been set
too high) but it has less to gain than when dividends were taxed at
the full rate.
Search terms used:
"unreasonable compensation" dividend closely-held
"qualified dividend" "unreasonable compensation
"s corporation" "unreasonable compensation
"taxable wage base" 2005
Thanks again for bringing us your question.
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