If you are the owner or part owner of a C corporation, you might think that your compensation plan is relatively straightforward. You pay yourself a salary to cover your living expenses during the year. At year end, if your company has made money, you pay yourself a bonus. Your company deducts the salary and bonus so it winds up with little or no net income and pays little or no corporate tax.
In such a scenario, you might be in for a shock. The IRS could say that your compensation is unreasonable. Par of your compensation may be recast as a dividend, subject to both corporate and personal income taxes.
Example: Grace Moran owns 100% of ABC, a C corporation. She pays herself a salary of $10,000 a month, or $120,000 a year. In 2011, Grace pays herself a $300,000 bonus. ABC reports no taxable income for 2011, and Grace pays personal income tax on her total income of $420,000.
The IRS examines ABCs corporate return and decides that Graces $120,000 salary is reasonable compensation for her efforts. The other $300,000 is classified as a dividend, bringing ABCs corporate income up to $300,000 for the year. Counting state and federal taxes, ABC owes about $100,000 in corporate income tax. Grace, meanwhile, also has to pay personal income tax on both the $300,000 dividend and her $120,000 salary.
Sidestepping the snare
With careful planning, your C corporation can avoid this tax trap. Possible strategies include
If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.