Software of the Month Club 1997 March/Software of the Month Club 1997 March.iso/pc/dos/lg/sba/f105.sbe

Text File | 1996-08-23 | 4.6 KB | 100 lines

@043 CHAP 8

           ┌─────────────────────────────────────────┐
           │   "UNREASONABLE" COMPENSATION PROBLEMS  │
           └─────────────────────────────────────────┘

Some closely-held C corporations try to escape from being
caught between a rock and a hard place (between double
taxation if dividends are paid, and accumulated earnings
or personal holding company penalty tax if income is
accumulated in the corporation) by raising the compensation
paid to the employee-owners (or their relatives on the
payroll) to levels high enough to zero out the corporate
income.

This works beautifully until the IRS audits the corporation
and decides that the compensation paid is unreasonably
high, and disallows part of it.  In that case, unless one
can convince the IRS (or a court) otherwise, the excess
compensation is treated as a constructive dividend and is
still fully taxable to the recipient, but not deductible to
the corporation.  This can also have other disastrous side
effects, such as disqualifying a pension or profit sharing
plan, where the contributions to the plan by the corporation
were based on the "unreasonable" compensation, rather than
the lesser amount the IRS allows as a compensation deduction.

@IF117xx]Because your business is currently a C corporation, you
@IF117xx]should be aware that some careful tax planning, in ADVANCE
@IF117xx]of the problem, may be needed it you become "too" successful
@IF117xx]and the issue of unreasonable compensation arises for you or
@IF117xx]other officers of @NAME.
@IF117xx]
S corporations generally do not have to worry about the issue
of "unreasonable compensation," although if compensation paid
is too low, the IRS may impute a higher level of salary
expense, which reduces an S corporation's net income, and
is thus a wash, overall.  The IRS will sometimes make such
an adjustment in the case of an S corporation where a parent
who runs a business has given stock to his or her children
and takes out little or no salary so that the corporation
will have more taxable income to be split with the children.
Or the IRS may argue that compensation is too low where an
employee-owner of an S corporation takes little or no salary
in order to avoid FICA and/or unemployment taxes. (There
will be no such payroll taxes if he or she takes all of the
S corporation's income out in the form of dividends, rather
than compensation, unless the IRS forces a recharacterization
of the "dividends" as disguised salary.)
@IF118xx]
@IF118xx]@NAME is an S corporation, so you have
@IF118xx]relatively little to worry about with regard to unreasonable
@IF118xx]compensation, except from the possible standpoint of taking
@IF118xx]too LITTLE compensation out of the corporation, as noted
@IF118xx]above.

A similar re-allocation of partnership income can occur in
a "family partnership" where there is an attempt to allocate
partnership income to children who have not earned it, and
similar rules will apply to LLCs, which are generally
treated as partnerships for tax purposes.

Sole proprietors don't have to worry about "unreasonable
compensation" unless making payments of salary or wages to
family members who do not earn the compensation.

@IF115xx]Thus, you are not likely to have to be concerned about any
@IF115xx]problems of "unreasonable" compensation, due to the fact that
@IF115xx]@NAME is a sole proprietorship.


NEW MILLION-DOLLAR LIMIT ON COMPENSATION

The Revenue Reconciliation Act of 1993 (also humorously
dubbed the Deficit Reduction package) contains a provision
you may have heard of that disallows deduction of payments of
over $1 million in compensation a year to certain corporate
executives.  If yours is a small business, you probably will
not have to worry about this limitation, since you aren't
likely to be taking a million dollars a year in salary out
of your corporation.  Even if you are, this new limitation
on compensation deductions (which went into effect in 1994)
only applies to:

  . "Publicly-held" corporations; and

  . Only to compensation paid to the top five executives
    of the corporation.

Finally, there are numerous ways around the limitation even
for the top 5 executives of a public company, such as payments
into a retirement plan or for other fringe benefits, and for
compensation based on performance, such as commissions, or
compensation that meets certain "outside" director and
shareholder approval requirements.

In short, don't lie awake at night worrying about this new
$1 million limit on executive compensation.  Almost no one
will be affected by it.