When it comes to salary, many business owners have no qualms about paying themselves a hefty amount. What many owners fail to recognize, however, is that you can get into big trouble at tax time if you inflate your own compensation.
Say you own a C corporation with $500,000 in profits (in other words, taxable income). You might be tempted to reduce that profit -- and thus reduce the percentage of it you have to pay Uncle Sam -- by giving yourself a well-deserved six-digit year-end bonus. Although that practice may not seem like a crime, the IRS is wary of such behavior, especially if it implausibly inflates an owner's salary given the business's size and industry. However, Richard M. Colombik, a lawyer and certified public accountant who runs International Tax Associates, in Schaumburg, Ill., stresses that you really need to be concerned only if you're paying yourself a megasalary. "It's rare that I've seen salaries of less than $500,000 get challenged," he says.
But that doesn't mean owners with modest salaries have nothing to fear. If you are the sole owner of an S corporation, you can also run afoul of the IRS for paying yourself too little. "There is an incentive to minimize compensation in order to save on employment taxes," says Steven Paul, a tax lawyer at Palmer & Dodge, in Boston. But this offense seldom triggers an audit for two reasons. First, owners of S corporations rarely do it, since they know that the government is going to nail them on their individual taxes anyway. Second, if the salary is equal to or over the FICA ceiling of $76,200, the IRS stands to recover only 2.9% of the excess, so it's probably not worth the agency's time.
What can you do to try to avoid an audit? Using comparable industry figures to justify salary and bonus levels always helps, notes Armand E. Epstein, a tax partner at Arthur Andersen in Boston. Documentation is also key. If you're a C-corporation owner, lay out your salary and bonus possibilities in your corporate minutes, and do it early in the year. (Inflated year-end bonuses are easy for the IRS to detect, since auditors can refer to the date of the disbursed check.) If you're an S-corporation owner, you probably don't need to fear problems at the federal level, but be careful to find out whether your state recognizes S corporations and, if so, how it taxes them.
Above all, see your accountant or financial adviser, since the reasonable-compensation issue hinges so much on location, industry, profitability, and corporate structure. Says Epstein, "There aren't many absolutes."