A C corporation is a type of business entity that gets taxed separately from its owners under Subchapter C of the Internal Revenue Code. Under state law, a C corporation is considered a separate legal entity distinct from its owners, or shareholders, and has many of the same rights as an individual. It can thus engage in business, enter into contracts, and initiate lawsuits. While not mandatory, employees can also be hired. If it chooses to do so, there are some rules regarding employee payment.
There is no law requiring a corporation to hire employees or pay them a salary. Once this type of company files its articles of incorporation, pays the required fees, and remains in good standing, it is considered a legal entity regardless of whether it hires 500 employees or none at all.
However, if the corporation is conducting business without any employees, the Internal Revenue Service (IRS) assumes that someone is acting on the business's behalf. Thus, it will classify any payment a person receives from the corporation as a salary, even if the owners did not intend the distribution as such.
The 60/40 Rule
Oftentimes, when a corporation is just in its beginning phase, its owners may choose to work for the operation for free until it can afford to hire employees. There is no requirement that the corporation pays them a salary. However, if they do accept payment for their services, the IRS has issued some guidelines that the team should follow.
One way an owner may elect to be paid is to take dividends and avoid paying payroll taxes, such as Social Security. Corporations usually distribute dividends on a regular basis, such as quarterly or once a year. While this practice is technically legal, the IRS frowns upon this, which may subject the business to a higher level of scrutiny.
Instead, the IRS has held that if a corporation is distributing profits to its owners and has not hired any other employees, it should follow the 60/40 rule. This rule states that 60 percent of the distribution should be treated as salary—and thus subject to payroll taxes—and the remaining 40 percent as dividends.
If the corporation does hire employees, the IRS is typically concerned with unreasonable or "excessive" salaries. To determine whether a salary is excessive, both the IRS and the courts focus on whether the compensation is reasonable for the services the employee performs. To determine whether it is reasonable, they conduct a "five broad factors" analysis, which considers the following:
- The employee's role in the organization
- An external comparison of similar corporations
- The character and condition of the corporation
- Potential conflicts of interest
- Internal consistency regarding compensation
If the employee's salary is deemed excessive and they are an employee-shareholder, the IRS can order the corporation to distribute the excessive portion of the salary as a dividend. In that case, the entity cannot deduct the amount from its gross income for tax purposes.
Salary rules for C corporations can get tricky. As long as you are in compliance with both the state laws your business operates in as well as the IRS, you won't have to worry about any legal consequences.
This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.
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