The IRS requires owners who run their businesses to pay themselves "reasonable compensation." Individuals who do not pay themselves reasonable compensation cannot deduct their salary as a business expense. While the IRS does not define reasonable compensation, the courts have historically considered several factors when determining whether compensation is reasonable. These factors include experience, duties and responsibilities, time and effort devoted to the business, and the salaries similar businesses pay for similar services.
C corporations are subject to double taxation. This means that profits are taxed at the corporate level and then again at the shareholder level. One common strategy to avoid being taxed twice on the same income is to set compensation equal to the corporation's profit, so that there is no income left in the corporation to tax. This is, however, a risky strategy because if the IRS determines compensation is too high, it may impose taxes on the portion of salary it deems excessive, along with additional penalties and interest. Moreover, the excess compensation will not be deductible as a business expense.
As many as 90 percent of entrepreneurs underpay themselves, according to CPA and business consultant Greg Crabtree. The motivation for underpaying oneself is often to save money. However, it has the adverse effect of distorting how the company is actually performing and potentially reducing your incentive to make the company more profitable. For example, if you pay yourself 50 percent below your market-based wage, you may calculate a profit at the end of the year. However, that profit may be attributable to your willingness to accept a below-market wage, rather than the strength of your corporation. As a result, you may not be addressing the financial problems of your corporation.
S Corporations and the 60/40 Rule
Some corporations can elect to be taxed as an S corporation. Unlike a C corporation, an S corporation is not subject to double taxation. This is because S corporations are not required to pay corporate income tax on profits. Rather, profits are passed through to the shareholders who then pay personal income tax on whatever share of the profits they receive. Consequently, overcompensation is not as common. Rather, a common strategy employed by owners of S corporations is to pay unreasonably low salaries in order to avoid paying employment taxes, such as Social Security and Medicare. One way to avoid paying too little compensation is to follow the 60/40 rule. The 60/40 rule essentially says to take 60 percent of profits as salary and 40 percent as distributions. The key is that your salary should never be less than distributions.