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 income tax.

In such a scenario, you might be in for a shock. The IRS could say that your compensation is unreasonable. Part 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 ABC’s corporate return and decides that Grace’s $120,000 salary is reasonable compensation for her efforts. The other $300,000 is classified as a dividend, bringing ABC’s 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:

  • creating a formal compensation plan. Your corporate minutes can explain the plan and report its adoption. Such a plan might call for owner-executives to receive a salary plus a bonus that’s determined by financial goals, such as revenues, profits, and market share. If you worked for years with little compensation, helping your company to grow, your minutes might state that some of your compensation is a makeup for prior sacrifice.
  • using external comparisons. Your compensation plan might refer to an industry study indicating that executives at other companies in your field are paid amounts comparable to those you are likely to receive. You might get such data from an industry association.
  • paying some corporate income tax. In the previous example, Grace could pay herself a $200,000 or $250,000 bonus, rather than a $300,000 bonus. That would leave some money in the company subject to corporate income tax. On the first $75,000 of corporate income, your company will pay only 15% or 25% in federal corporate income tax.
  • paying some dividends. Taking some profits as double-taxed dividends can indicate you are not “zeroing out” corporate income to avoid tax.
  • making an S corporation election. Your company must meet several criteria (for example, it can have only one class of stock). But, if your company meets these criteria and makes the election, it will be an S corporation and, therefore, will not be subject to corporate income tax.
2011 Q1 | You and Your Company Can Avoid the Disguised Dividend Tax Trap
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