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‘Reasonable Compensation’ Can Be Sticky for a Small Business

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Structuring your business as a corporation offers certain advantages — especially the protection you get from being held personally liable for the debts of the business. But it also brings tax complications. One of the biggest involves your own income from the company. If you work for your corporation, you generally must pay yourself a salary of an amount the IRS considers “reasonable compensation.”

Further, reasonable compensation is viewed differently depending on whether you form a regular corporation or a “Subchapter S” corporation, a specific type of corporation designed for small businesses.

Literally hundreds of U.S. Tax Court cases deal with reasonable compensation. In a nutshell, reasonable compensation is what you would get paid to do the same job anywhere else. For example, if you are a web designer and people in your business typically get paid $64,000 a year, then you would pay yourself at least $64,000 in compensation (assuming the business generated enough money to do so).

You may want to increase your compensation, however, because the more you pay yourself, the more you can put into retirement plans. For instance, you can start a Solo 401(k) and put up to $54,000 a year into it, but only based upon your compensation. After you reasonably compensate yourself, you can take a distribution of the remaining profit from your corporation. Unlike the salary you paid yourself as an employee of the company, this distribution is paid to you as a shareholder.

What’s ‘reasonable’ in an S corporation

S corporations don’t pay federal income tax; instead, all profits and losses flow to the shareholders, who report them on their personal tax returns. There, it is subject to income tax but not self-employment tax. Self-employment tax is simply a self-employed person’s Social Security and Medicare tax, and in most cases it is 15.3% of net income. If you operate a business as a sole proprietorship, meanwhile, you pay self-employment tax on all your net income. If you’re in a partnership, you pay self-employment tax on any guaranteed payments to yourself, as well as your share of the net income from the business.

Being taxed as an S corporation would seem to eliminate self-employment tax. However, if you work for your S corporation, you have to pay yourself reasonable compensation. For example, if your company makes a profit of $100,000, people in your line of work make an average of $64,000, and you pay yourself a salary of only $20,000 and take the rest as a distribution of profit, then you aren’t reasonably compensating yourself.

The effect in a C corporation

In a traditional corporation, known as a C corporation, reasonable compensation is completely different. C corporations pay federal corporate income taxes on their profits. If you, as the owner, take distributions of corporate profits, you pay tax on them, too, on your personal tax return. This is what is known as double taxation.

Even though a C corporation pays taxes while an “S-corp” does not, there are times when it makes more sense to operate as a C corporation. For instance, the highest personal tax bracket is 39.6%. If you’re in the 39.6% tax bracket, you might be better off operating as a C corporation, because the highest corporate tax bracket is 35%.

Additional considerations

In an S-corp, paying yourself too little in salary is a bad thing, because the IRS may see it as an attempt to duck self-employment taxes. In a C corporation, by contrast, paying yourself too much in salary can be a bad thing. Salary is a deduction against corporate income, so the IRS might say you’re trying to evade corporate income taxes by paying yourself a large salary. Using the same situation as before, if you’re in the web design business, you would still pay yourself a salary of $64,000. You can either pay yourself the remaining profit in a distribution or leave it in the business as retained earnings.

A potential problem with leaving the money in the corporation is that there’s also an “accumulated earnings tax” for C corporations — a penalty tax imposed on companies that the IRS believes are holding onto profits to avoid paying their shareholders taxable dividends. It is much smarter tax planning to pay less of a salary in a C corporation than it is in an S corporation. Money you receive in a salary from a C corporation will be taxed at a higher rate than dividends from the corporation, which for most people are taxed at no more than 15%.

As you can see, reasonable compensation is different depending on whether you operate as an S corporation or a C corporation. Before deciding which type of corporation you should be, talk to a tax accountant.

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