Shareholders’ Compensation vs. Dividends: An Important Distinction for C Corporations

The IRS and closely held C corporations often disagree about the reasonableness of compensation paid to shareholder-employees. The company wants to classify payments to shareholder-employees as deductible compensation expense. But the IRS would prefer to classify some of the payments as nondeductible dividends. Here's what C corporations should consider when addressing the treatment of payments to shareholder-employees for federal income tax purposes.

Owners' Compensation Basics

The Internal Revenue Code allows a business to deduct a "reasonable allowance for salaries or other compensation" it pays to executives and other employees. Compensation can include:

• Salary,
• Bonuses,
• Pre-tax employee contributions to tax-favored retirement accounts, such as 401(k) accounts, and
• The value of company-paid benefits and perks, such as personal use of company vehicles, sporting event tickets and country club memberships.

The IRS typically focuses on salary and bonuses, often ignoring other forms of compensation unless they're highly excessive.

When an executive or employee is also a shareholder of the C corporation, his or her compensation shouldn't exceed what similar companies typically pay for comparable services. The IRS may challenge shareholder-employee compensation it believes is unreasonably high, arguing that the excess constitutes a disguised dividend.

Double Taxation of Disguised Dividends

When the IRS reclassifies excess compensation as dividends, the payments will be subject to two levels of tax. First, the corporation loses out on the compensation deductions and must pay corporate income tax on those earnings. Second, recipient shareholder-employees are taxed on amounts treated as dividends. Taxable dividend treatment occurs to the extent the corporation has accumulated earnings and profits (similar to retained earnings).

The Tax Cuts and Jobs Act (TCJA) reduced the federal income tax rate on C corporations to a flat 21%. However, double taxation remains undesirable and should be avoided whenever possible.    

You can't necessarily avoid double taxation by leaving funds inside your C corporation instead of making payments that will constitute taxable dividends to shareholder-employees. Why not? First, most shareholders want to get cash out of their companies. Second, failure to distribute dividends can expose the corporation to the accumulated earnings tax (AET). This is essentially a federal penalty tax on retained corporate earnings and profits, beyond what's deemed to be needed for corporate business purposes. The following amounts of retained earnings and profits are automatically AET-exempt:

• $250,000 for C corporations, and
• $150,000 for personal service corporations.

When the IRS assesses the AET, the rate is the same as the maximum federal income rate individual taxpayers owe on dividends (20%). However, the rate could increase if Congress increases tax rates on dividends.

Generally, the best way to avoid double taxation of dividends and the AET is to maximize deductible compensation provided to shareholder-employees. This includes salaries, bonuses and fringe benefits. Maximizing deductible compensation expense minimizes the corporation's annual taxable income. However, there's a catch: The compensation payments must be reasonable. That determination can be subjective, so it's essential to assess your situation carefully in light of IRS guidance.

Factors Used in Determining Reasonable Compensation

C corporations should be prepared to support their deductions for compensation paid to shareholder-employees. But reasonableness is in the eye of the beholder, and there are no bright-line rules. In many cases, the founders of a closely held C corporation have made significant personal sacrifices, taken on multiple roles, and served as the driving force behind the company's success over the years. During times when cash was tight, they might have been grossly underpaid.

Here's a checklist of factors, grounded in IRS guidelines and relevant legal precedent, to assess whether your shareholder-employee compensation deduction meets the test of reasonableness:

Shareholder-Corporation Conflict of Interest Factors

• Would a hypothetical outside investor conclude that return on shareholder equity has been maintained at acceptable levels by avoiding excessive compensation provided to shareholder-employees? (Based on recent court decisions, the independent investor test now appears to be the most critical factor in assessing the reasonableness of compensation paid to shareholder-employees. When the return on equity is inadequate, the IRS may attribute it to unreasonably high compensation.)
• Is it clear that shareholder-employee stock ownership percentages don't simply determine compensation levels? (Consider documenting in corporate minutes that compensation is based on the value of the services each shareholder-employee provides.)  
• Does the company have a history of paying dividends? (This isn't a critical factor. A dividend-paying history can only help support the reasonableness of compensation deductions. However, the mere fact that no dividends have been paid doesn't prove that compensation is unreasonable.)

Company-Specific Factors

• Are the company's revenue and profits healthy and growing?
• Are the company's key financial ratios favorable?
• Is the company performing above average for its industry?
• Is the nature of the business itself unique, complex or highly specialized?

Employee-Specific Factors

• Does the shareholder-employee's length of service and past contributions demonstrate a commitment to the company?
• Does the shareholder-employee handle multiple functions, such as marketing, human resources, financial management, sales and product development?
• Does the shareholder-employee have extensive experience in the company's line of business?
• Does the shareholder-employee possess specialized skills, advanced education or a unique "package" of attributes?
• Does the shareholder-employee have an exceptionally high workload?
• Are the other fringe benefits provided to the shareholder-employee — such as retirement plan and health insurance benefits — modest? (When devising compensation packages for shareholder-employees, take advantage of fringe benefit programs. Fringes can provide significant value, but the IRS tends to focus primarily on salary and bonuses.)
• Has the shareholder-employee been underpaid in the past? (The IRS is more likely to accept progressive annual compensation increases than sudden spikes. However, it's well-established that significant increases are justifiable if they're intended to make up for periods of low compensation. Reasonable compensation should be measured over years rather than just one year at a time.)

Compensation Policy Factors

• Does the company have formal compensation policies, and have they been followed? (This factor is especially important when the company appears to pay large year-end bonuses to reduce the company's annual taxable income. Bonuses should be paid under written plans that are consistently followed, and yearly bonus allocations should be documented in the corporate minutes.)
• Was the company's bonus plan designed and overseen by an outside advisor, such as a CPA or compensation planning professional?
• Can the company show that at least some nonshareholder-employees' compensation levels have been set using similar guidelines to those used to determine compensation levels for shareholder-employees?

Comparability Factors

• Is there market-based evidence that the shareholder-employee's compensation is comparable to compensation received by employees rendering similar services to similar businesses? (It's helpful to document comparable salary data in the corporate minutes.)
• Is the shareholder-employee's role in the company so unique that it's unrealistic to compare that individual to employees of other similar businesses? (For instance, a shareholder-employee who founded the company may be a proven innovator or a so-called rainmaker.)

Tallying Up the Results

When using this checklist, affirmative answers indicate that reasonable compensation is likely, while negative answers suggest the opposite. However, having some "No" responses won't automatically result in IRS scrutiny. Determining reasonable compensation is more art than science, and each factor's importance depends on situational facts.

Contact your tax advisor for additional guidance on reasonable compensation. With proper planning and documentation, you can manage this issue with confidence.