If you’re the owner of an incorporated business, you probably know that there’s a tax advantage to taking money out of a C corporation as compensation rather than as dividends. The reason is simple. A corporation can deduct bonuses and salaries for business owners and executives that it pays, but not its dividend payments. Therefore, if funds are withdrawn as dividends, they’re taxed twice, once to the corporation and once to the recipient. Money paid out as compensation is taxed only once, to the employee who receives it.
However, there’s a limit to withdrawing cash from a business account from the corporation this way. Under tax law, one can deduct compensation only to the extent that it’s reasonable. Any unreasonable portion isn’t deductible and, if paid to a shareholder, may be taxed as if it were a dividend. The IRS is generally more interested in unreasonable compensation payments made to someone “related” to a corporation, such as a shareholder or a member of a shareholder’s family.
There’s no simple formula. The IRS tries to determine the amount that similar companies would pay for comparable services under similar circumstances. Factors that are taken into account include:
There are some concrete steps you can take to make it more likely that the compensation you earn will be considered “reasonable,” and therefore deductible by your corporation. For example, you can:
Planning ahead can help avoid problems. Contact our accounting firm in Mundelein, IL if you’d like to discuss this further.