Toll Free: 877.880.

4477
Phone: 281.880.6525

Paying Yourself Too Much Too Little Be

Ready for an IRS Challenge

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It is generally more tax-efficient to be paid a salary than to receive dividends,

given that salary expense is deductible and dividends are paid on an after-tax
basis. If the IRS thinks some portion of your salary really should be treated as
a distribution of profit, that portion would be added to the pool of corporate
revenue subject to tax.
It all comes down to the meaning of the word "reasonable.

It all comes down to the IRS

definition of "reasonable."

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"Whether the pay is reasonable depends on the circumstances that existed

when you contracted for the services, not those that exist when the
reasonableness is questioned," according to the IRS.
Suppose, for example, you paid yourself a $250,000 salary at a time when
your company was small, with gross revenue of $500,000, two employees
besides yourself, and you were not working around the clock.
Suppose further that after five years your business has tripled in size and you
are still paying yourself $250,000.

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Timing Counts
If the IRS determined that, five years ago, a "reasonable" salary for your
business would only have been $130,000, you'd have to pay corporate taxes
on the extra $120,000 for that period. This is based on the finding that
anything above $130,000 is deemed to be excessive and thus a "constructive
dividend."

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So how does the IRS assess reasonableness? There is no hard and fast rule; it's
a matter of "facts and circumstances." But these are the key factors they will
likely consider:

Your duties,
Volume of work,
Level of responsibility,
Complexity of the business,
Time spent on the job,
Local cost of living,
Your skill level and professional achievements,
The relationship between the pay and the net income of the business,
plus level of corporate distributions, and
Overall pay policies and payment history.

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Return on Equity Metric

Another approach used by courts, when companies decide to fight an adverse
ruling from the IRS, is to apply a return-on-equity (ROE) calculation. The
rationale behind the calculation was laid out in a landmark court ruling from
1999.*

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This metric determines the company's ROE after the executive salary is
factored in. So if the salary is such that it drives the ROE down to a level most
investors would consider unreasonable for that industry, then the salary is too
high. Here's an example of how this works. Let's say you decided that a 10
percent return on equity is reasonable for your industry. You could just set
your salary at the limit of what would still allow a hypothetical investor to see
that 10 percent ROE achieved.
Let's say the company has a bad year or two and the ROE is sub-par. Would
the IRS then expect the executive salary to be slashed to the point where ROE
is again acceptable to a hypothetical investor? Not necessarily.
But if the company's fortunes were lagging over a period of time, a downward
salary adjustment might be needed to keep it safely in the "reasonable"
range.

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Payroll Tax Avoidance

What about underpaying yourself if you're running an S corporation? Why
would you want to do such a thing? The answer is payroll tax minimization.
Since the company's earnings flow through to shareholders' individual tax
returns, those earnings will be taxed at the personal level no matter what. But
when paid out as distributions of profit, generally those are not subject to
payroll taxes.

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The IRS staked out its position on that topic a long time ago in IRS Revenue
Ruling 59-221, which it subsequently elaborated on in IRS Private Letter Ruling
(PLR) 131363-02.
"Generally ... if a shareholder of an S corporation performs services for the
corporation, any distribution to the shareholder, even if legally declared under
state law by the S corporation as a dividend, will be characterized as 'wages'
subject to employment taxes where in reality the payments are for services,"
the IRS informed a taxpayer in that PLR.
The PLR concluded as follows: "An S corporation cannot avoid employment
taxes merely by paying the corporate shareholder 'dividends' in lieu of
reasonable compensation for services performed.

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Note: A private letter ruling only applies to the taxpayer who requested it. It
cannot be relied on as precedent by other taxpayers. But it can a good
indication of how the IRS would rule in a similar situation.
To assess whether an S corporation shareholder is taking a salary that's too
low, the IRS will analyze the compensation similarly to how it would assess
excessive compensation. Fundamentally, it will determine whether the
shareholder performed services for the corporation, and if so, apply its
reasonableness methodology to check for low-balling.
Whether you need to justify a high or low salary, the bottom line is ... have
good documentation. The longer you have been operating under written
compensation policies and procedures that incorporate competitive market
data, the stronger a case you can make.

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