Reasonable Compensation
If your business is prospering, you may be tempted to pay yourself and other key employees generously to minimize taxes on your C corporation. But the corporation can deduct only compensation that is considered "reasonable." There's no set dollar amount (a $1 million deduction limit applies only to publicly-held corporations). What's reasonable depends on what you do for the compensation package (job responsibilities, skills, education) and what's common for the industry you are in and the area in which you are located. The question of reasonable compensation is one of the most litigated issues with the IRS, so any steps you can take to preempt an IRS challenge is advisable.
Research the job market to determine what you think is reasonable. To see what others are paying, visit these sites:
* Bureau of Labor Statistics of the U.S. Department of Labor (www.bls.gov)
* CareerInfoNet (www.acinet.org)
* Salary.com (www.salary.com)
* World At Work (www.worldatwork.org)
Show that current compensation is making up for low compensation paid in prior years. For example, if you chose to reinvest profits in past years, foregoing compensation you were otherwise entitled to, higher-than-normal pay now is considered reasonable in light of the overall picture.
Consider what a hypothetical investor would approve for compensation, allowing for a return on his or her investment. If the corporation is paying dividends to shareholders, then it is in a good position to prove that compensation is reasonable, even if it appears to be high.
Backup plan: Usually it's up to you to prove that compensation is reasonable. But if the IRS audits you on this issue and you go to court, you can shift the burden of proof to the IRS as long as you have presented credible evidence of reasonableness. To shift the burden of proof, the corporation's net worth cannot exceed $7 million.
S corporations. The flipside scenario applies to S corporations; since corporate income passes through and is taxed directly to owners, there is a tendency to minimize compensation payments as a way to keep down payroll taxes (including FICA and FUTA). But this approach can also draw IRS attention. It has argued successfully that reasonable compensation must be paid to owners who perform services for their S corporation. Again, use industry standards to establish the lower end of what's reasonable.
