Posted by: Coto Legal Services, PLC | March 12, 2011

Year End Bonuses for C Corp

Year End Bonuses- is this really effective tax planning?

In a C corporation that declares dividends, the profit is taxed twice.  Once when  the corporations earns the profit at the entity level and reports the profits on the corporate tax return (Form 1120), then when these  profits are distributed to its shareholders in the form of a dividend, the share holder is again taxed on this dividend income on his personal return.    Corporations are not allowed a deduction for a dividend distribution, so dividend income is subject to double taxation.

Many advisors attempting to avoid double taxation, advise their clients to distribute this income as deductible bonuses or additional compensation, not as non-deductible dividends.

Consequently, in a C corporation, the IRS scrutinizes owner salaries to determine if any of this compensation is excessive and the excessive compensation should be reclassified as a dividend.  If the IRS does reclassify the excessive compensation as dividends, the excessive compensation deduction, along with the associated payroll taxes deduction will be disallowed, resulting in significant interest and penalties.

Tax law requires compensation to be reasonable, which allows the IRS to determine if the compensation of an employee is reasonable for the personal services that were actually rendered.   The courts have considered the following principal factors to determine the reasonableness of a salary: 1) the qualifications of the employee; 2) the employee’s contribution to the success of the business and 3) how the employee’s salary compares to the salaries of similar employee positions in the same industry.

Therefore,  we believe that generally  bonuses are an ineffective tax planning device.  If these bonuses are excessive and unreasonable, this compensation will be re-classified as dividends which may result in an assessment of substantial interest and penalty charges.   Furthermore,  even if these bonuses are  not considered to be excessive, this compensation is subject to payroll taxes, which results in substantial payroll taxes.

Isn’t the idea of tax planning  is to reduce all types of taxes, including payroll taxes?  So, instead of bonuses or compensation, we believe that there are other ideas that will save you taxes when taking money out of the company which will benefit the owners.

In a future post, I will discuss compensation issues for an S corporation.

Coto Legal Services, PLC focuses on estate, probate, tax and busisness law matters.  Contact us if you have any questions or need a consultation.  We will save you taxes ! Website:  cotolegal@com;  E-mail: rcoto@cotolegal.com.

This information on this blog is not intended to be legal advice and viewing this blog does not create an attorney-client relationship.


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