If a corporation pays a shareholder-employee a salary that’s unreasonably high considering the services actually performed, the IRS may treat the excessive part of the salary as a constructive distribution of earnings to the employee-shareholder. The employee-stockholder’s wages are reduced, and the difference is treated as a dividend. This creates increased corporate taxable income and tax liability for the corporation since the reduced wages increase the corporation’s earnings but the cash to pay the additional tax is gone. There are also penalties and interest to be paid on the underpayment. To avoid this compound effect, the corporation and shareholder-employee can enter into a Compensation Reimbursement Agreement.

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