Question: I currently own a sole proprietorship and want to incorporate my business and form a corporation, but feel held back by the reasonable salary requirement as the business does not make very much money. Since the big companies are able to pay $1 salaries, would I be able to do the same? The IRS requires that the compensation of CEOs and other corporate officers must be reasonable – I read in the news that some big CEO is only being paid $1 for his salary? How is this reasonable?
Answer: You’re always free to incorporate and pay yourself whatever you like, but in order to deduct corporate salaries and/or save on self-employment taxes in the case of an S-corporations, the IRS requires that an officer’s salary be “reasonable compensation” within applicable IRS guidance and judicial standards. However, whether a salary is “reasonable compensation” depends on the facts and circumstances of the business and your duties, and as such, what constitutes “reasonable compensation” for you at your small business would be much different than “reasonable compensation” of the CEO of a large multinational. However, with this in mind there are some important things for entrepreneurs to understand when considering what “reasonable compensation” is.
The threshold question here would be whether you intend your corporation to be taxed as a regular C-corporation, with two layers of tax (taxes applied to the corporation’s profits, and then again on distributions to the shareholders), or whether the corporation is taxed as an S-corporation, with one layer of tax (earnings at the corporate level are not taxed and instead passed through to the shareholders where they are taxed).
Reasonable Compensation & C-Corporations
With a C-corporation, a common strategy is to pay salaries that roughly approximate the corporation’s earnings, so that the corporation will not have much, if any, taxable income at the corporate level. However, the IRS, in its continued efforts to increase the tax base, does not like this, and will often assert that this is excess compensation (the portion of the salary beyond what is reasonable compensation), and is not a deductible corporate expense pursuant to IRC Section 162. In order to be reasonable and therefore deductible, the salary expense must be “ordinary and necessary,” however, the IRS does not provide a specific definition of what is “reasonable” or “ordinary and necessary,” so the issue can be somewhat complicated and unclear if you are not familiar with the concepts. As such, in the case of a C-corporation, the IRS is typically looking to decrease salaries paid to CEOs and other officers within the concept of “reasonable compensation.”
Reasonable Compensation & S-Corporations
In contrast, in the instance of an S-corporation, as there are no corporate-level taxes, a common strategy is to pay as little of a salary to corporate officers as possible in an effort to avoid payment of taxes at ordinary income rates and to reduce applicable employment taxes. When salaries are paid, they are taxed at ordinary income rates, and applicable employment taxes are also assessed. However, if its a closely held company, the officers and shareholders are typically the same, and as such, if the company’s earnings are instead paid out as dividend distributions, which are often taxed at a much lower effective tax rate than payments made as wages, and in addition, employment taxes are not paid on dividend distributions. As such, in the instance of a closely-held S-corporation, the IRS has the opposite goal, it wants higher wages to be paid so that it can collect more in taxes.
What It All Means
Big companies, particularly publicly traded companies, are typically taxed as C-corporation, and as such, they often want to pay higher salaries to their corporate officers to get a higher corporate-level deduction and pay less in taxes. In contrast, it is very common for smaller, closely-held companies to be taxed as S-corporations, and as such, they often want to pay lower salaries to obtain favorable capital gains rates and avoid employment taxes. The IRS obviously has the opposite in mind, and uses the concept “reasonable compensation” to attack unreasonably high or low corporate salaries, depending on the manner the company is taxed.
With the above in mind, there is plenty of literature and case law on point to help you in paying yourself a “reasonable salary,” and if done correctly, you can end up saving yourself a lot in the way of taxes. What is reasonable depends on a number of factors, including the amount of money the corporation earns and the level of responsibility the officer has, but this is a facts and circumstances based concept. I have included a link below to an IRS website that should be helpful in making this determination, however, I strongly recommend that you seek the guidance of an experienced tax attorney, CPA, or other tax advisor, as these are complicated tax issues. You can both save yourself a lot of taxes or get yourself into a lot of trouble depending on how you choose to have your corporation taxed and how much of a salary you pay yourself as the CEO.
The IRS provides the following guidance on “reasonable compensation” for corporate officers on its website:
Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to “Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses for more information.