Overview
In the S corporation arena, tax advisors generally do not focus much attention on unreasonable compensation. As we delve into the issue in this Part VII of my multi-part series on Subchapter S, it will become apparent that reasonableness of compensation in the S corporation setting is important. Failure to pay attention to the issue can place S corporations and their shareholders in peril.
Closely held C corporations have historically been incentivized to distribute profits as compensation to shareholder employees. A corporation is allowed, under IRC § 162(a)(1), to deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.” There is, however, no corresponding deduction for dividend distributions, which end up being taxed twice: once at the corporate level upon earning the income that funds the dividend, and again at the shareholder level upon receipt of the dividend. Consequently, treating distributions of profits as compensation for services rendered could significantly reduce a corporation’s tax liability.