Gerald Kramer
The AZ CPA
5350 N 16th St
Phoenix, AZ 85016
(602) 264-9331
Fax: (602) 279-1766
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Tax-efficient Owner-employee Compensation: C Corps. Vs. S Corps.
Owners of closely held corporations who are actively involved in the day-to-day operations of their companies often ask us about the most tax-efficient way for them to take money from their businesses. The answer typically depends upon whether there is an S election in place for the corporation.
Dual Roles
If you are a working shareholder in a regular C corporation or an S corporation (which passes income and losses through to the shareholders), certain tax strategies are available because you may play the dual roles of owner and employee. One strategy both S and C corporation owners may use is the reduction of Social Security and Medicare taxes through the payment of low salaries and bonuses, provided the payments are "reasonable" for the work performed. (See discussion of "reasonable compensation" below). However, this strategy could work to the net disadvantage of some C corporation owner because amounts not taken as pay increase the company's taxable income and ultimately may have to be distributed as dividends, which are also subject to income taxes at the individual level.
If your company is a regular C corporation, think about setting up a system that rewards you in the form of salary, bonuses, and fringe benefits, rather than dividends, subject to the "reasonable compensation"considerations discussed below. This strategy helps avoid the double taxation that would result from dividend distributions.
On the other hand, by limiting some of the owners' compensation, a C corporation generally can take advantage of the 15% federal tax rate on the first $50,000 of corporate earnings. Accumulating some earnings in the business may also be worthwhile if the business is likely to be sold, subject to a low capital gain tax rate. If you choose either alternative, take into account, and avoid, the accumulated earnings tax, which applies when a C corporation retains an excessive amount of earnings and profits in the company instead of paying dividends. Reasonable compensation may be another issue to consider.
Reasonable Compensation
Whether you have a C corporation or S corporation, always keep the IRS's insistence on "reasonable compensation" in mind. If your compensation is substantial and your C corporation writes it off as a tax-deductible expense, the IRS can disallow the "unreasonable" part of the compensation package. If that happens, the IRS will reclassify the excess as a dividend which is taxable to you, but not deductible by the corporation. President Bush's Plan may help here.
Similarly, if your S corporation pays you an excessively low salary, the IRS may view it as unwarranted avoidance of employment taxes and recharacterize other distributions the corporation has made to you as salary.
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