Determining how much a business should pay its owners is never easy. You’ve got to consider a variety of factors, including just what form (salaries, benefits, stock) that compensation will take. You also need to ensure your approach will hold up under IRS scrutiny.
Let’s start with the basics. Compensation is affected by the amount of cash in your company’s bank account. But just because your financial statements report a profit doesn’t necessarily mean you’ll have cash available to pay owners a salary or make annual distributions. Net income and cash on hand aren’t synonymous.
Other business objectives — for example, buying new equipment, repaying debt and sprucing up your office — will demand dollars as well. So, it’s a balancing act between owners’ compensation and dividends on the one hand, and capital expenditures, expansion plans and financing goals on the other.
If you operate as a C corporation, your business is taxed twice. First, business income is taxed at the corporate level. Then it’s taxed again at the personal level as you draw dividends — an obvious disadvantage to those owning C corporations.
C corporation owners might be tempted to classify all the money they take out as salaries or bonuses to avoid being double-taxed on dividends. But the IRS is wise to this strategy. It’s on the lookout for excessive compensation to owners and will reclassify above-market compensation as dividends, potentially resulting in additional income tax as well as interest and penalties.
The IRS also monitors a C corporation’s accumulated earnings. Generally similar to retained earnings on your balance sheet, accumulated earnings measure the buildup of undistributed earnings. If these earnings get too high and can’t be justified as needed for such things as a planned expansion, the IRS will assess a tax on them.
Other business structures
Perhaps your business is structured as an S corporation, limited liability company or partnership. These are all examples of flow-through entities that aren’t taxed at the entity level. Instead, income flows through to the owners’ personal tax returns, where it’s taxed at the individual level.
Dividends (typically called “distributions” for flow-through entities) are tax-free to the extent that an owner has tax basis in the business. Simply put, basis is a function of capital contributions, net income and owners’ distributions.
So, the IRS has the opposite concern with flow-through entities: Agents are watchful of dealer-owners who underpay themselves to avoid payroll taxes on owners’ compensation. If the IRS thinks you’re downplaying compensation in favor of payroll-tax-free distributions, it’ll reclassify some of your distributions as salaries. In turn, while your income taxes won’t change, you’ll owe more in payroll taxes than planned — plus, potentially, interest and penalties.
Red flags, higher taxes
Above- or below-market compensation raises a red flag with the IRS — and that’s definitely undesirable. Not only will the agency evaluate your compensation expense — possibly imposing extra taxes, penalties and interest — but a zealous IRS agent might turn up other challenges in your records, such as nonsalary compensation or benefits.
What’s more, it might cause a domino effect, drawing attention in the states where you do business. Many state and local governments face budget shortages and are hot on the trail of the owners’ compensation issue and will follow federal audits to assess additional taxes when possible.
Other interested parties
Other parties also might have a vested interest in how much you’re getting paid. Lenders, franchisors and minority shareholders, for instance, could think you’re impairing future growth by paying yourself too much.
Plus, if you or your business is involved in a lawsuit, the courts might impute reasonable (or replacement) compensation expense. This is common in divorces and minority shareholder disputes. In these situations, you’d be wise to consult an attorney early in the compensation decision-making process.
The best practice in owners’ compensation is to see to it that you’re being fairly compensated — and that you’re in line with industry figures. Avoid red flags, and your decisions should be able to withstand outside scrutiny.