To be transparent, I currently own a sole proprietorship and want to change entities to a corporation but feel held back by the reasonable salary requirement as the business does not make enough money to afford to pay a reasonable salary. Since the big companies are able to pay $1 salaries, how would I be able to do the same?
I don't do tax law, but "reasonable salary" has to do with the other end: overpaying the CEO (salary is a deduction) as a substitute for a dividend (dividends are not deductions.) You can take less than fair market value or an honorarium.
By the way, no business succeeds without the assistance of a coompetent CPA.
The above is general legal and business analysis. It is not "legal advice" but analysis, and different lawyers may analyse this matter differently, especially if there are additional facts not reflected in the question. I am not your attorney until retained by a written retainer agreement signed by both of us. I am only licensed in California. See also avvo.com terms and conditions item 9, incorporated as if it was reprinted here.
1 found this helpful
5 lawyers agree
The threshold question here would be whether you intend your corporation to be taxed as a regular C-corporation, with two layers of tax (taxes applied to the corporation's profits, and then again on distributions to the shareholders), or whether the corporation is taxed as an S-corporation, with one layer of tax (earnings at the corporate level untaxed and passed through to the shareholder where they are taxed).
With a C-corporation, a common strategy is to pay salaries that roughly approximate the corporation's earnings, so that the corporation will not have much, if any, taxable income at the corporate level. However, the IRS, in its continued efforts to increase the tax base, does not like this, and will often assert that this is excess compensation (the portion of the salary beyond what is reasonable compensation), and is not a deductible corporate expense pursuant to IRC Section 162. In order to be reasonable and therefore deductible, the salary expense must be "ordinary and necessary," however, the IRS does not provide a specific definition of what is "reasonable" or "ordinary and necessary," so the issue can be somewhat complicated and unclear if you are not familiar with the concepts. As such, in the case of a C-corporation, the IRS is typically looking to decrease salaries paid to CEOs and other officers within the concept of "reasonable compensation."
In contrast, in the instance of an S-corporation, as there are no corporate-level taxes, a common strategy is to pay as little of a salary to corporate officers as possible in an effort to avoid payment of taxes at ordinary income rates and employment taxes. When salaries are paid, they are taxed at ordinary income rates, and applicable employment taxes are also assessed. However, if its a closely held company, the officers and shareholders are typically the same, and as such, if the company's earnings are instead paid out as dividend distributions, such payments will typically be taxed as capital gains, which are often taxed at less than half of the rate of payments made as wages - in addition, no employment taxes are paid on dividend distributions. As such, in the instance of a closely-held S-corporation, the IRS has the opposite goal, it wants higher wages to be paid so that it can collect more in taxes.
Big companies, particularly publicly traded companies, are typically taxed as C-corporation, and as such, they often want to pay higher salaries to their corporate officers to get a higher corporate-level deduction and pay less in taxes. In contrast, it is very common for smaller, closely-held companies to be taxed as S-corporations, and as such, they often want to pay lower salaries to obtain favorable capital gains rates and avoid employment taxes. The IRS obviously has the opposite in mind, and uses the concept "reasonable compensation" to attack unreasonably high or low corporate salaries, depending on the manner the company is taxed.
With the above in mind, there is plenty of literature and case law on point to help you in paying yourself a "reasonable salary," and if done correctly, you can end up saving yourself a lot in the way of taxes. What is reasonable depends on a number of factors, including the amount of money the corporation earns and the level of responsibility the officer has, but this is a facts and circumstances based concept. I have included a link to an IRS website below that should be helpful in making this determination, however, I strongly recommend that you seek the guidance of an experienced CPA, tax attorney, or other tax advisor, as these are complicated tax issues, and you can both save yourself a lot of taxes or get yourself into a lot of trouble depending on how you chose to have your corporation taxed and how much of a salary you pay yourself as the CEO.
Best of luck with your business!
This advice is for INFORMATIONAL PURPOSES only and should not be relied upon as legal advice. No attorney-client relationship shall be formed as a result of the answer above.
1 found this helpful
6 lawyers agree
If your business, when organized as a Corporation, cannot pay you a reasonable salary, then it simply does not. The minutes of the company and/or your employment agreement can reflect that fact that in consideration for your taking a smaller salary to allow the company to survive, you will get a larger bonus if the company succeeds. This may have the added benefit of not violating unreasonably high salaries if you do succeed and want to avoid double-taxation of C Corporation earnings.
The $1 salaries of large corporations are often gimmicks. The reality is that the CEO is taking his hoped-for profit through stock options.
This answer is provided for general information only. You should seek advice from an attorney or tax professional.
1 found this helpful
3 lawyers agree