4 Ways Corporate Business Owners Can Help Ensure Compensation is “Reasonable”
If you own a C corporation, you’re likely aware of the tax advantages associated with taking money out as compensation rather than as dividends. While dividends can be subject to double taxation—first at the corporate level and then again when distributed to shareholders—salaries and bonuses paid to executives are deductible by the corporation, effectively being taxed only once at the individual level. However, determining what constitutes “reasonable” compensation is crucial, particularly in the event of an IRS audit. Here are four strategies to help ensure that your compensation is viewed as reasonable and thus deductible by your corporation.
1. Benchmark Against Industry Standards
One of the first steps you can take is to keep your compensation in line with what similar businesses are paying their executives. Conduct market research to find out average salaries and bonuses for your position in your industry. Document this information and retain any evidence you gather, as it can serve as a benchmark during an audit. The IRS will likely consider these comparisons when determining whether your compensation is reasonable.
2. Document Compensation Decisions
Proper documentation is key to supporting your compensation levels. Be sure to contemporaneously document the reasons for the compensation paid in the minutes of your corporation’s board of directors meetings. For example, if you decide to increase compensation in the current year to make up for previous years when it was lower, make sure the meeting minutes reflect this decision. Additionally, cite any executive compensation studies or industry reports that justify your compensation amounts. This proactive approach can help demonstrate that your compensation decisions are well-founded and based on sound reasoning.
3. Avoid Proportional Payments to Shareholders
When determining compensation, steer clear of paying amounts that are directly proportional to the stock owned by the corporation’s shareholders. This practice can be viewed as a disguised dividend by the IRS, which could jeopardize the deductibility of your compensation. To maintain a clear distinction between compensation and dividends, ensure that your payment structure reflects the value of the services rendered rather than merely the ownership stake.
4. Consider the IRS’s Interest in Related Party Transactions
The IRS tends to scrutinize compensation payments made to individuals related to the corporation, including shareholder-employees and their family members. If you are in this category, be particularly mindful of how your compensation is structured. The IRS may be more likely to challenge payments perceived as excessive or unreasonable. To mitigate this risk, follow the earlier strategies, particularly documenting your compensation decisions and ensuring they align with industry standards.
Plan Ahead
Navigating the complexities of reasonable compensation can be challenging, but careful planning can help you avoid potential pitfalls. If you have questions or concerns about your compensation structure or need assistance ensuring compliance with IRS regulations, don’t hesitate to reach out. Contact Guerrero CPA at 210-490-7100. for personalized guidance tailored to your specific situation. Our team is here to help you navigate the intricacies of corporate compensation and optimize your financial outcomes.