How to Determine a “Reasonable” Salary for Corporate Owners and Officers

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By Asha Inamdar

Owners and officers of S corporations and C corporations may adjust the amounts of compensation they receive from various sources in order to lower taxes. However, according to US tax law, officer compensation must be “reasonable” to be tax deductible. It is imperative to consult an experienced CPA to develop a reasonable compensation structure for your company’s leadership.

C Corporations: Tax Advantages of Salary Payments

C corporations enjoy tax savings when they pay more of their officers’ compensation in the form of salary and bonus payments, rather than as dividends. This is because executive salaries are tax deductible for corporations, and only taxed once at the individual level. Dividends are taxed twice: once at the corporate level, and again at the individual level.

Excessive officer salaries attract the attention of the Internal Revenue Service (IRS). The IRS is most concerned with the salaries of people “related” to the business, such as shareholders and their families. If the IRS determines that a portion of a exceeds what is “reasonable,” and the salary deduction may be denied and it may be taxed like dividends.

S Corporations: Benefiting from Compensation as Dividends

S corporations do not pay federal taxes. Their taxes are “passed through” to the owners who pay tax on their compensation. Officers of an S corporation are considered its employees. Their income is divided between their share of the profits and their salary.

These businesses must pay employment taxes on employee salaries and withhold a portion of wages for payroll taxes. S corporations may try to lower owners’ tax burden by giving officers a lower salary and increasing the other forms of compensation that they receive.

Calculating a “Reasonable” Salary for C Corporation and S Corporation Officers

The IRS provides a few guidelines for determining a “reasonable” salary for officers. While all factors are important, the IRS weighs factors slightly differently for C corporation officers versus those of S corporations.

Reasonable Salaries for C Corporation Officers

The IRS evaluates an employee’s professional background, and the business’s nature and practices when deciding whether compensation is “reasonable” for C corporations. It considers the following:

  • Employee Information:
    • Duties and the time invested to complete them
    • Skills and achievements
    • Compensation history
  • Business Information:
    • Business complexity
    • Gross and net income
    • Salary policy for all employees

Reasonable Salaries fsor S Corporation Officers

When deciding whether compensation is reasonable for officers of S corporations, the IRS examines factors related to the officer’s pay, the business’s compensation history, and the practices of similar businesses. These factors include:

  • In-house compensation practices:
    • Whether compensation is calculated using a formula
    • Compensation of non-shareholder employees
    • History of dividends paid to employees
    • Timing and practices related to paying bonuses to key officers
    • Agreements for compensation
  • Competitor comparisons:
    • What similar businesses pay for similar job duties
  • Employee Information:
    • Training and experience
    • Duties and responsibilities
    • Time and effort devoted to the business

Employee information is particularly critical to calculating S corporation compensation. The more experienced and involved an employee is, the higher his/her salary should be. If the business relies on the personal services of one or more shareholders to generate revenue, the IRS looks for a higher proportion of compensation to be in the form of wages. If, however, the business relies on a substantial investment in equipment for its revenue, officers can receive a higher proportion of their compensation as dividends, or stock.

How to Ensure Corporate Compensation is “Reasonable”

Businesses should first explore how much local companies in their industry would pay a similarly experienced person for comparable services. They should document this evidence and use it to structure their compensation.

Both S corporations and C corporations should use a formula to calculate compensation for employees, or at least officers of the corporation. For example, officer compensation can be calculated as a percentage of net income, subject to changes in net income. Businesses should document the reasons for any compensation changes in their board minutes.

C corporations should take special care to avoid paying salary in direct proportion to stock, since this would attract the IRS to treat these salary payments as dividends. Profitable C corporations should pay at least some dividends to officers to avoid raising red flags.

Conclusion

There is no one-size- fits-all formula for calculating reasonable officer compensation for S corporations and C corporations. Reach out to an experienced Chugh CPAs, LLP professional for help developing a compensation structure that is reasonable for your company.