As the owner of an incorporated business, you may know that taking reasonable compensation rather than dividends from a C corporation can result in tax benefits. This is because a corporation can deduct salaries and bonuses paid to executives but not dividend payments.
Dividend Payments vs. Compensation
Dividend payments are subject to double taxation, once to the corporation and once to the recipient. In contrast, compensation is taxed only once, to the employee who receives it. However, tax law limits the amount of compensation that can be deducted to what is considered reasonable. Any amount deemed unreasonable is not deductible and may be taxed as a dividend if paid to a shareholder.
What is Considered Reasonable Compensation?
The IRS is particularly interested in compensation payments that are considered unreasonable and are paid to someone related to the corporation, such as a shareholder-employee or a shareholder’s family member. The determination of what is considered reasonable compensation is not straightforward. If the IRS audits your tax return, it will compare the amount paid by your corporation for similar services under similar circumstances to what other companies are paying. Several factors, including duties, time spent, skills, expertise, compensation history, complexity of the business, and gross and net income, are taken into account.
To increase the chances of your compensation being considered reasonable and therefore deductible by your corporation, take the following steps:
- Ensure that your compensation is consistent with what similar businesses pay their executives. Keep evidence of what others are paying to support what you pay.
- Document the reasons for compensation paid in the minutes of your corporation’s board of directors’ meetings. If compensation is being increased in the current year to make up for earlier years in which it was low, ensure that the minutes reflect this. Cite any executive compensation or industry studies that back up your compensation amounts.
- Avoid paying compensation proportional to the stock owned by the corporation’s shareholders as it may be treated as a disguised dividend by the IRS.
- Pay at least some dividends if the business is profitable. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.
By planning ahead, you can avoid potential problems and challenges. If you have questions or concerns about your situation, consider contacting one of our tax professionals for assistance.
Originally published April 21, 2021. Updated May 2023.