The level of compensation you draw from your business undoubtedly will vary widely due to the ebb and flow of your personal and business needs. If your business is structured in any way other than a C corporation, the business profits "flow through" directly to your personal income tax return. Since your compensation isn't technically a deduction for the business, it won't be attacked by the IRS as unreasonable. Similarly, you do not have to worry about allowing too much profit to accumulate within the business, as you do with a C corporation.
Because a C corporation is a separate "person" from its owners, money flowing through a C corporation is taxed twice: once on the corporate tax return as the profit from the business and again on the individual's tax return as compensation or dividends paid by the business. Because of this double taxation, many small businesses are organized as S corporations, partnerships, proprietorships or, limited liability companies (LLCs), although recent tax changes may make the C corporation more attractive.
With a C corporation, it's usually a good idea to keep your compensation as regular and level as possible to avoid waving any red flags at the IRS. Paying yourself too little can, in many cases, get you into just as much trouble as paying yourself too much, because your corporation can find itself paying "accumulated earnings tax." Bunching compensation into lump sums at the end of the year is also not a recommended practice--unless the payments were established and documented early in the year as part of a "bonus" program. Otherwise, even if the overall amount is acceptable, the timing could call it into question.
As a general rule, the ultimate objective in your business is a C corporation is for you to obtain the maximum cash and benefits at the minimum tax cost. The catchword in this relationship is "reasonable" in the eyes of the IRS. You may be paid what you deem to be a reasonable amount, but the IRS may not define "reasonable" in the same way. In this event, their interpretation will often prevail and will usually carry with it increased tax liability thus ruining your maximum-cash for minimum-tax equation.
The criteria for judging "reasonable compensation," as determined by years of IRS examination and litigation, include:
- the nature and size of the business claiming the deduction
- the nature and scope of the work you do for the business
- any special qualifications you may have
- the availability of others to perform the same duties
- general economic conditions
- compensation compared to business income and profits
- compensation relative to dividends
- compensation relative to other employees
- compensation relative to stock ownership if the business is a corporation with more than one shareholder
- your compensation history for past services
You can, of course, pay yourself what you like. The IRS can't enforce a cap on you. But what they can do is prevent your corporation from enjoying the benefits of deducting your unreasonable compensation. They do this by recharacterizing some of it as constructive dividends. And if this is done, you can bet there'll be a penalty assessed. And penalties are, you guessed it, non-deductible to your C corporation as well.
Why would anyone want to have a C corporation, what with all these drawbacks?
Well, in the early years of your company it has generally been recommended that you use a proprietorship or other flow-through entity, as these allow you to offset your personal income with the business losses typical of new companies. But as you start to become profitable, a C corporation has some handy attributes.
- limited liability: the company is liable for its own debt (this is also true of LLCs and S corporations)
- stock issuance accommodates multiple owners if necessary for future growth
- perpetual life (this may be true of LLCs and S corporations)
- tax favored as long as its annual profits don't exceed $50,000 and it's not a Personal Service Corporation
- the entity is allowed to retain earnings so its stock value appreciates, which could be thought of as a kind of deferred compensation
- it may be easier to obtain bank financing and additional capital as a corporation
And as the years go by, and you grow old and gray (and rich) and are ready to depart this world for a better one, the appreciated stock of your C corporation could be passed down to your children at a stepped-up basis, free of any income tax whatsoever on that appreciated value and possibly even avoiding estate tax depending on the circumstances. Also, recent tax changes may make the C corporation more attractive.