Because the American Taxpayer Relief Act of 2012 changed only individual tax rates (corporate rates stayed the same), the law changed the effects of paying compensation vs. dividends. 

For large corporations, the issue of compensation is straightforward, since employees are so far removed from the corporation itself. But for small corporations with owner-employees who control whether amounts are paid as compensation or dividends, the issue becomes more complex. What constitutes reasonable compensation? And what strategy should be used to reduce the double-taxation on corporate earnings?

The Strategies

Since qualified dividends are taxed at a maximum rate of 20% (or 23.8% if they are subject to the net investment income tax), it’s desirable to pay out some amount of a corporation’s income in the form of dividends instead of paying compensation.

In the past, most closely held C corporations avoided double taxation of corporate earnings by paying salary and bonuses to shareholder-employees to “zero out” the corporation’s income— resulting in having this amount taxed only once at the employee level. (However, these salaries and bonuses are subject to Social Security and Medicare taxes and possibly to an additional 0.9% Medicare tax for wages above a certain amount.) If this strategy allows for “reasonable compensation” requirements to be met, it’s can still be a worthwhile strategy, particularly if the owner falls into the 25% tax bracket.

Another strategy to consider is to have shareholder-employee compensation levels that reduce corporate income to $50,000. The first $50,000 of corporate income is taxed at 15%, so total federal corporate income tax would be $7,500 ($50,000 × 15%). The remaining $42,500 would be paid out to the shareholder-employee as a dividend. Corporate Taxation Insider illustrates this strategy in charts. This strategy can result in significant savings over the previous strategy as the owner’s tax bracket goes higher.

Reasonable Compensation Factor

With any strategy, the compensation paid to shareholder-employees must be considered, by law, to be “reasonable.” Although the law doesn’t specifically define “reasonable,” the courts have based their decisions on two tests: the multiple-factors test and the hypothetical-investor standard.

The Multiple-Factors Test

The multiple-factors test weighs compensation against the following factors:

  • Employee qualifications
  • External comparison of employee salaries with those paid by similar companies for similar services
  • Character and condition of the company
  • Any conflict of interest in the relationship between the company and its employees that “would permit the company to disguise nondeductible corporate distributions as salary”
  • Internal consistency in how bonuses and other compensation are calculated and paid to controlling shareholders compared to non-owner management. 

The Hypothetical-Investor Standard

The hypothetical-investor standard asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated. Independent investors are looking for a return on investment, so they want to see a certain amount of money retained in the corporation to be paid as the return. So courts have calculated how much a reasonable return on investment would be, and determined that the difference between this amount and the amount retained is unreasonable compensation.

If you are the owner of a small corporation and have questions about tax strategy, give me a call  at (864) 836-3136, and we’ll schedule an appointment.