Excessive Owner Compensation – C Corporation
The IRS permits a business to deduct as a business expense, a “reasonable” salary, as compensation for services performed by employees and business owners. For obvious reasons, the owner’s salary if deemed to be excessive in relationship to services performed, industry standards, and geographical location, could potentially be reclassified by the IRS as a partial dividend. One of the significant differences of how a C Corporation is taxed, is the potential for double taxation. Corporate profits are taxed once at the corporate level, and taxed again when they are paid to the owner(s). Hence the double tax concept.
In an ill-advised attempt to avoid this double taxation, business owners and their advisors pay all “excess” money out to the owners as salaries. Salaries paid to owners are 100% deductible by the company as an ordinary and necessary business expense. Dividends on the other hand are not deductible by the company, hence the desire to pay salary in lieu of dividends. This is exactly why this issue is attractive to the IRS. The portion of the salaries deemed to be excessive would be reclassified as a dividend. As a dividend, the expenditure is not deductible, so the company would have additional income, resulting in additional taxes, penalties, and interest. The payroll tax previously paid by the company would be forfeited. The penalties generally are equal to the tax due.
How can this be avoided? Strategic, and proactive tax planning, entity structuring, and choice of entity planning can avoid these problems by creating other acceptable and tax friendly owner compensation options.
Source: Tim, our business tax expert!