S Corp and C Corp Considerations for Reasonable Compensation
C Corp considerations for reasonable compensation:
Wages paid to a shareholder as an employee of a corporation are deductible by the 
corporation and taxable to the shareholder. Wages are not double-taxed, as is the case with dividend distributions (dividends are not deductible by a C corporation and are taxable to the shareholder). This creates an incentive for a shareholder in a C corporation to take as high a wage as possible in order to minimize taxes on corporate earnings. If compensation is determined to be excessive, the excess over the amount considered reasonable may be treated as “constructive” dividends instead of deductible wages.
The IRS may challenge the deductibility of year-end bonuses, especially when such bonuses appear to be distributions of corporate profits rather than merited rewards for performance during the year.
S Corp considerations for reasonable compensation:
The primary concern with S Corporations is not excessive compensation, but inadequate compensation. If an S corporation is not paying a “reasonable” salary to a shareholder who provides services to the corporation, distributions to that shareholder may be recharacterized as wages subject to payroll taxes.
Having distributions reclassified as wages can be expensive. The corporation must pay the FICA and FUTA on the wages, and may be required to pay income tax withholding of 28% of the wages. The corporation will be subject to the failure to file penalty, the failure to deposit penalty (if payroll tax returns were not filed), and conceivably, the negligence penalty.
Substantial tax advantages can be gained by S corporations using compensation to achieve certain objectives. As a result, a significant portion of IRS activity in the S corporation area is directly or indirectly related to the reasonableness issue. Those areas are:
- Reallocation of S corporation income among family members
- Minimizing salaries to reduce payroll taxes
- Using compensation to minimize built-in gains and passive investment taxation
- Reducing salaries to change character of shareholder’s income
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Photo Credit: Boaz Yiftach