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In one case, the tax court found "reasonable" compensation of almost $900,000 for one year paid by a corporation to its only owner. This compensation consisted of a $200,000 salary, a $400,000 bonus, and a $296,000 lump sum retirement benefit.
The tax court relied on five factors in deciding whether the compensation was reasonable:
- the employee's role in the business
- a comparison of the compensation with what is paid to similar employees by other companies
- the character and condition of the business
- whether, in a regular C corporation, the compensation is really a "disguised dividend" intended to avoid the double tax on dividends
- whether the compensation was consistently paid under a structured and formal arrangement
The fourth factor underscores why these tax cases arise. A regular or C corporation is a separate tax-paying entity. Dividends paid by a C corporation are subject to a double tax, because they are not deductible by the corporation and thus are taxed at the corporate level. Dividends also are taxed a second time, at the individual tax rates when they are received by the owner. C corporations sometimes attempt to disguise a dividend as salary, in an attempt at avoiding the tax at the corporate level, as the salary is deductible by the corporation. The salary is considered to be a disguised dividend, only to the extent the salary is deemed to be unreasonable.
While the same tax issue does not arise in the case of the subchapter S corporation or the limited liability company (LLC), the reasoning should extend to actual fraud cases. Payment of a reasonable salary is not indicative of fraudulent intent.
Note, too, that the fifth factor formally recognizes authorization and documentation as important factors in determining the reasonableness of the salary.
Between payments for salary, loans and leases, and other withdrawal strategies, it will seldom be a problem for small business owners to withdraw all of the vulnerable funds from the business in a manner that is "reasonable," and thus not found to be fraudulent.
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