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Sole proprietorships may deduct wages paid to employees, but the owner of the business is not considered an employee and the owner's salary or draw is not deductible. All the net profits of the business are taxable income to the owner, and self-employment tax applies to the entire amount.
In a partnership, LLC, or S corporation, some partners or owners may receive salaries (known as guaranteed payments), but all of the business's profits for the year will ultimately be taxable to the partners or owners, so the reasonableness of the compensation is rarely an issue.
But in a C corporation, the situation is very different. Payments made to an employee who is also the owner of the C-corporation are subject to very close scrutiny by the IRS, because salaries paid to owner/employees are deducted before the corporate income tax is imposed. Any after-tax corporate profits that are distributed are treated as dividends to the shareholders and taxed at their individual income tax rates. The difference between the corporate income tax rates and the individual income tax rates sometimes tempts business owners to inflate their salaries to get a larger deduction against the corporate income tax.
As a result, the IRS has made a practice of investigating the reasonableness of compensation paid to stockholder/employees in C corporations. If your compensation is determined to be out of line, it could be treated as a disguised, nondeductible corporate dividend, and your compensation deduction could be denied.
However, you can put up a defense against the recharacterization of salary as a disguised dividend if you can establish that your personal efforts, highly specialized experience, or technical ability allowed your corporation to receive extraordinary revenues. If this doesn't sound easy to prove, that's because it's not!
Other factors to consider. What else might trigger a challenge to compensation paid to an owner-employee? Often, some portion of the salary paid to owner-employees is held to be disguised dividends if a corporation hasn't paid any dividends or has only paid nominal dividends during its existence, and has, at the same time, paid unusually large salaries to employee-owners. Does your corporation have to issue dividends to escape this kind of challenge to a deduction for compensation? Not necessarily the failure to pay dividends is not conclusive evidence that compensation is a disguised dividend, but it is a significant factor. You may be able to present legitimate business reasons for not paying dividends, such as the need to conserve capital for expansion. Or, perhaps it may have been more prudent to reinvest the earnings of your business if it's relatively new.
Another factor that increases the likelihood of disallowance is a close relationship between salaries and stockholdings. If an employee's salary closely tracks his or her stockholdings, it's strong evidence that the salary is in fact a disguised dividend payment.
If you are in the situation where you are the only owner-employee in your company (the only shareholder) but your company has other employees that aren't shareholders, the IRS is apt to take a second look at your compensation if it exceeds compensation paid to the nonshareholder employees. If you find yourself in this situation and you don't want the IRS to recharacterize your compensation payment as a dividend, you should be ready to explain and prove that the reason your compensation is higher is because of differences in duties or responsibilities.
Finally, does your compensation exceed compensation paid by other companies to similarly situated employees? If so, you may have a problem claiming a compensation deduction. The IRS may grant you more leeway if you can show that the success of the business is almost entirely dependent on your efforts and, therefore, you deserve a higher salary.