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Tax Rules And Proper Pay For Small Businesses
BY HARRY RABB, C.P.A.
 Compensation might be questioned by the IRS if it's too large or too small... 
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Special to Tropical Breeze
The recent disclosures of huge pay packages for some of the nation’s prominent CEOs raise a question for small businesses as well: How much should the owner or top executives of a small firm be allowed to earn?
Technically, when you’re the owner, you can draw whatever size paycheck you want. But if your business is a corporation, the amount of your compensation might be questioned by the IRS if it’s too large or too small.
The IRS is paying closer attention to compensation amounts at companies known as S corporations, so owners in general should be prudent about the salaries and bonuses they draw. If the compensation is deemed “unreasonable,” they’ll charge you penalties and interest on top of the tax they are able to collect.
If you’re a sole proprietor and file Schedule C along with your 1040, there are no limits on your compensation. The income from your business flows directly to you and is taxed along with your other personal income. Your banker will want to know what you take home if you apply for a loan, but there’s really no one else you must answer to.
In a traditional partnership, how the partners are compensated is entirely up to them. They’re also taxed on their 1040s.
With corporations, problems arise when the government decides that an owner or top executive is earning too much or too little, depending on whether the company is what’s known as a C corporation or an S corporation. Both names come from Internal Revenue Code provisions.
In the more traditional C corporation, the company is taxed on what it earns and when earnings are paid out to shareholders as dividends. The shareholders are also taxed on that income. This is what’s known as double taxation but it is derived from the fact that, legally, a C corporation is deemed to be a “person.”
Compensation problems arise in C corporations when an owner or top executive is overpaid by IRS standards. Compensation is tax-deductible to the corporation and it also reduces the amount of money payable as dividends to shareholders, lowering the double taxation burden. The IRS looks to see if a company is trying to skirt some of these taxes through big compensation.
In an S corporation, the company’s earnings are not taxed. They’re instead “passed through” to shareholders, who pay individual taxes on the income.
With an S corporation, the IRS is concerned that owners might take too little in pay to avoid payroll taxes. |
With an S corporation, the issue is that owners might take too little in pay. The government’s concern is that companies might be trying to avoid payroll taxes, which are levied on compensation but not dividends.
Whether you have a C corporation or an S corporation, the IRS will look at what is a reasonable salary for an owner or top executive of a company in a given industry and a given geographic area.
But there are no hard and fast rules. The facts and circumstances of each individual’s situation will determine what an owner’s pay should be.
As with many other financial issues, it’s best to sit down with a financial professional to answer not just questions about taxes, but your company’s overall fiscal picture. Under some circumstances it might make more sense to leave money with the company for capital purposes, rather than taking it out in salary or bonus for yourself.
A problem that many small business owners face is that they don’t know at the beginning or the middle of the year what business is going to be like, and therefore what kind of pay they should draw. Some companies take smaller salaries during the year and then, at the end of the year, the shareholder/owner is paid a larger bonus, thus managing the “reasonableness” of the total compensation.
As with all complex and complicated tax and financial matters, please confer first with a CPA or financial professional to assist in navigating through what can be treacherous waters.
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This information is provided as a public service and should not be construed as individual accounting or tax planning advice. For information on how these general principles apply to your situation, please consult an accounting or tax professional.
Harry Rabb is a C.P.A. and owner of Accounting Services, Inc., 935 Main Street, Suite D-1, Safety Harbor. Call 727-725-4121.
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