Can You Have a Corporation Without Paying Salaries?

by Terry Masters

Once an owner forms a corporation, there is no law that requires it to hire employees or pay salaries. Legally, the corporation exists as long as articles of incorporation are on file with a state and the company remains in good standing by filing any required reports or information updates with the state business registrar. If the company is conducting business, however, it is the opinion of the Internal Revenue Service that someone must be acting on the corporation's behalf. In that case, any money the person receives from the corporation will likely be classified as salary, whether or not the owners intended the distribution to be viewed that way.

Legal Authority

The incorporation statute of the state where the corporation has filed its articles of incorporation governs it activities. That law establishes the corporation as a separate entity with many of the rights of an individual and grants it authority to act in its own name. One of the powers the law gives corporations is the ability to hire people. The exercise of this authority is discretionary and not mandatory, however. A corporation has the legal right to employ hundreds of people or none at all.

Perpetual Existence

A corporation comes into existence when it files articles of incorporation with the state. The viability of that document is the only barometer of the existence of a corporation. If a business presents itself in every way like a corporation but has not filed articles with a state, it cannot be treated as a corporation under the law. Likewise, if a business with filed articles of incorporation does nothing to further its business activities, it would still exist as an entity until someone files articles of dissolution and effectively withdraws the incorporation paperwork from the state.

Ownership Withdrawals

When a corporation is in startup phase, it is common for the owners to work for the corporation until the business can afford to hire employees. Nothing requires the owners to draw a salary from the corporation. The owners are within their rights to work for their business for free. Sometimes, however, owners work for the company and take withdrawals as profits, also known as dividends, to avoid paying payroll taxes on the money. These dividends are sometimes distributed periodically, such as every quarter, or once a year. Technically, this practice is perfectly legitimate from a legal standpoint. It often runs afoul of the IRS, unfortunately.

The 60/40 Rule

The IRS wants to make sure it collects payroll taxes on income. If people are allowed to classify infusions of cash as dividends or some other category of payment, the payroll taxes that support the economy, such as Social Security taxes, will diminish. Although a corporation can operate without paying a salary, if it is making money and distributing profits, the IRS figures someone must be doing the work and classifies that person as an employee. The IRS has held that if a corporation is distributing profits to owners and the owners are the only ones working for the company, 60 percent of the distribution should be treated as salary and only 40 percent as dividends. Owners are free to disregard this rule of thumb but other distribution plans can expose the corporation to heightened IRS scrutiny.