Today I would like to write about excessive compensation. Excessive compensation applies to business owners who draw a salary from their own business. If you are in business for yourself, you have total control over how much you pay yourself out of the profits of your business or practice. Simply put, the more salary or compensation you draw from your business, the higher the tax you have to pay. This is because salaries (and bonuses) are tax deductible expenses of the business.
But if your practice pays you a dividend, then the amount you owe in taxes increases significantly because of a unique “double tax” on dividends. This is because dividends are not tax deductible expenses; instead they are considered taxable profits. So if you pay dividends to yourself, you have to pay taxes on two fronts – the business pays corporate taxes and you pay individual taxes on the same dividend.
Now you may be tempted to convert all dividends into salaries or bonuses to save on your tax bill. It’s not so simple. That’s because the amount of deduction your business can claim from your salary is only to the extent that your salary is “reasonable”. The test for “reasonable compensation” is whether your salary compares to a salary that would reasonably be paid for services by other like businesses in like circumstances. The IRS also takes into consideration other factors such as your personal ability, the responsibility of the position you hold and the economic conditions in the locality where your business is run.
The criteria for “reasonable compensation” does sound quite arbitrary therefore the US Court of Appeals in the Seventh Circuit has come up with some concrete guidelines. Basically, if a profitable business can pay its owner a salary or bonuses and still have sufficient profits to provide an investor with a reasonable return on his investment, then the compensation should be considered “reasonable.” So this means you can only convert dividends into salaries up to the amount that the salary is considered “reasonable” by the court.
If you convert too much of your dividends into salaries i.e. you pay excessive compensation, the court will re-characterize your salaries into dividends and the effect will be that your business’ tax bill will be significantly increased because dividends are taxable profits. The amount you pay in personal income tax would not change because income, whether classified as salary or dividend to you, is still income.
One other way to avoid double taxation on your business is to leave the money in your practice. But that would carry a problem of its own. Such a move is subject to an “accumulated earnings tax.” This is an extra tax, in the form of a penalty, imposed on a business that accumulates profits or earnings instead of distributing them. Although the rate of tax on improper accumulations is 39.6% of “accumulated taxable income,” it can be reduced with a special credit.
The accumulated earnings credit allowed is an amount equal to the part of the earnings and profits retained for the “reasonable needs” of the practice. A minimum amount of $250,000 ($150,000 for personal service corporations) may be accumulated from past and present earnings combined.