How Much Should You Pay Yourself?

April 13, 2006

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The level of compensation you draw from your business will undoubtedly vary widely from time to time due to the ebb and flow of your personal and business needs. And if your business is organized in any structure other than a C corporation, your compensation isn't technically a deduction to the business so it won't be attacked by the IRS. C corporations suffer from the double taxation syndrome, and it is for tax reasons that many small businesses are now organized as S corporations, partnerships, proprietorships or, most recently, limited liability companies (LLCs).

With a C corporation, it's usually a good idea to keep your compensation as regular and level as possible to avoid waving any red flags at the IRS. Paying yourself too little can, in many cases, get you into just as much trouble as paying yourself too much. Bunching compensation into lump sums at the end of the year is also not a recommended practice. Even if the overall amount is acceptable, the timing could call it into question.

As a general rule, the ultimate objective for a C corporation is to draw the maximum cash and benefits at the minimum tax cost. And the catchword in this relationship is "reasonable." You may draw what you deem to be a reasonable amount, but the IRS may not define "reasonable" in the same way. In this event, their interpretation will often prevail and will usually carry with it increased tax liability — thus ruining your maximum-draw for minimum-tax equation.

The criteria for judging "reasonable compensation," as determined by years of IRS examination and litigation, include:

the nature and size of the business claiming the deduction
the nature and scope of the work you do for the business
any special qualifications you may have
the availability of others to perform the same duties
general economic conditions
compensation compared to business income and profits
compensation relative to dividends
compensation relative to other employees
compensation relative to stock ownership if the business is a corporation with more than one shareholder
your compensation history for past services

You can, of course, pay yourself what you like. The IRS can't enforce a cap on you. But what they can do is prevent your corporation from enjoying the benefits of deducting your unreasonable compensation. They do this by recharacterizing some of it as constructive dividends. And if this is done, you can bet there'll be a penalty assessed. And penalties are, you guessed it, non-deductible to your C corporation as well.

Why would anyone want to have a C corporation, what with all these drawbacks?

Well, in the early years of your company it is generally recommended that you use a proprietorship or other flow-through entity, as these allow you to offset your personal income with the business losses typical of new companies. But as you start to become profitable, a C corporation has some handy attributes.

These include:

limited liability: the company is liable for its own debt (this is also true of LLCs and S corporations)
stock issuance accommodates multiple owners if necessary for future growth
perpetual life (this may be true of LLCs and S corporations)
tax favored as long as its annual profits don't exceed $50,000 and it's not a Personal Service Corporation
the entity is allowed to retain earnings so its stock value appreciates, which could be thought of as a kind of deferred compensation

And as the years go by, and you grow old and gray (and rich) and are ready to depart this world for a better one, the appreciated stock of your C corporation can be passed down to your progeny at a stepped-up basis, free of any tax whatsoever on that appreciated value.

Unreasonable compensation is, in a way, a really nice problem to have. If you're paying yourself so much in salary and bonus that the IRS is hassling you, that means your business must be hugely successful.