IRS Reasonable Executive Compensation

C CORPORATION

A regular or "C" corporation is a distinct legal entity. That means a corporation is:

• separate from its owner(s)

• AND

• an independent tax entity

Any owner may also be an employee of the corporation. The shareholder-employee (as an employee) receives a salary like any other employee. This salary is a deductible expense to the corporation. The shareholder-employee can also be the recipient of a variety of fringe benefits that are deductible expenses on the part of the corporation. However, the amount of salary that can be deducted is limited.

IRC Section 162 (m) limits deductible compensation, including commission-based and performance-based compensation, to $1 million for the CEO, CFO and the three other highest paid officers of a public corporation. (The American Rescue Plan Act (ARPA), for tax years beginning in 2027, requires corporations to also treat the five next-highest-compensated individuals as covered employees bringing the total to 10.)

Dividends

As a shareholder, the shareholder-employee is entitled to distributions from the company in the form of dividends. These dividends are taxable to the shareholder-employee as ordinary income. Unlike an S corporation, there is no pass-through income. The C corporation is a separate taxable entity and pays taxes on its profits at the corporate rate.

The kicker in this is the dividends; they aren't a deductible expense to the corporation. From a tax standpoint, dividends don't reduce the profits of the corporation,although they reduce the cash of the corporation. The shareholder-employee will be motivated to maximize wages and minimize dividend distributions.

Q: Why will the shareholder-employee be motivated to maximize wages and minimize dividend distributions?

A: Because of the "double taxation" that results from paying dividends.

Double taxation

The profits of any business are subject to corporate income tax. When any portion of these profits is distributed to shareholders, the distribution is also taxed as income to the shareholder. In most people's eyes, this is a case of "double taxation."

Q: How can a company reduce this tax burden?

A: Don't distribute earnings as dividends; keep them in the corporation as retained earnings or pay them out as wages. Unlike dividends, the company can deduct wages as an expense, but there can also be penalties for retaining too much of a corporation's earnings. For more on this, see DLC Course 42: Accumulated Earnings and Deferred Compensation.

Fringe Benefits

In a C corporation, fringe benefits are deductible expenses to the corporation and aren't income to the employee. The C form of incorporation also allows the corporation to develop a wide range of incentives for executives (such as stock option and deferred compensation programs). Again, see DLC Course 42: Accumulated Earnings and Deferred Compensation.