Deciding on a salary depends on industry, legal structure, and profitability. The key to avoiding trouble with the IRS is determining what's reasonable
Are there industry guidelines for how much officers of small companies (less than 10 employees) should pay themselves? Would it be 1% of sales? 10%?
—F.K., Hartford, Conn.
Officers' salaries can vary dramatically between industries and even within industries based on the size and profitability of the companies involved. "The compensation level for corporate officers in any industry will be based on the growth and profitability of the company. Often, there's a base salary and a yearend bonus based on profits," says Steve Kunkel, a Los Angeles CPA.
While there's no standard percentage of income upon which to base an officer's salary, most companies arrive at a figure based on the competitive rate of pay for people in similar jobs, in similar sales-volume companies, in the same industry. "The smaller the organization and the smaller the income, the higher the percentage might be," says Mae Lon Ding, a compensation consultant and president of Personnel Systems Associates in Anaheim Hills, Calif.
"It is typical for very small S-Corporations and LLCs to pay out 100% of the profits—not the revenue—to the owners," she notes. "If you're asking about non-owners or C-Corporations, you should use published survey data for the industry, size group, and geographic location of your company. Sources vary according to the part of the country in which the business resides." You can find comparables and purchase compensation surveys at Salary.com.
An IRS Heads-Up
If yours is a C-Corporation, be aware that compensation of officers and shareholders may raise tax concerns with the IRS. (Unreasonable compensation is not typically an issue with the IRS for an S-Corporation or LLC, since those entities pay no corporate-level tax.) With a C-Corporation, which can deduct compensation but not dividend payments, there is a tax advantage to taking money out of the corporation as salaries and bonuses rather than as dividends. Also, if dividends are paid, they are taxed once as income earned by the corporation and re-taxed when they are reported by the dividend recipient. Money paid out as compensation is taxed only once—to the individual who receives it.
However, there is a limit on how much money you can take out of the corporation as compensation, Kunkel says. "The tax law provides that compensation can be deducted only to the extent that it is deemed 'reasonable,'" he says, noting that as a practical matter, the IRS rarely raises the issue of unreasonable compensation unless the payments are made to a shareholder or a shareholder's relative.
Keep Good Minutes
Deciding how much compensation is "reasonable" gets back to finding comparable rates of pay in similar companies for officers with similar job duties, abilities, backgrounds, and accomplishments. "There are a number of steps that can be taken to make it more likely that the compensation level will be considered reasonable and therefore deductible by the corporation," Kunkel says. He outlined several:
Use the minutes of the corporation's board of directors to document the reasons for the amount of compensation paid. If compensation is being increased in the current year to make up for earlier years in which it was too low, make sure that the minutes reflect this.
Avoid paying compensation in direct proportion to the stock owned by the corporation's shareholders. The IRS might look on that practice as disguising your dividends.
Keep compensation in line with what similar businesses are paying their executives—and maintain supporting documentation to show this.
If your C-Corporation is profitable, be sure to pay at least some dividends to shareholders. "This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation," Kunkel notes.
Even if you have an S-Corporation or an LLC, you should maintain documentation that supports your decisions about what to pay both employees and shareholders—just in case you face IRS challenges. An unreasonably low S-Corporation salary could be questioned or viewed as a dodge to avoid the payroll taxes that are incurred on salary payments but not on the pass-through income reported on an S-Corporation owner's IRS Schedule K-1, Kunkel says.
Obviously, salaries are more complicated than you might have realized. If your company can afford it, you might engage a compensation consultant to help you with these decisions, Ding says. She recommends that you get a referral to a local consultant from WorldAtWork, a nonprofit compensation organization based in Scottsdale, Ariz.