IRS Reasonable Executive Compensation

Example 3: Black Mesa Products as C Corp

Scenario #1

Assuming the same conditions from Examples 1 and 2, Andy and Loren will pay taxes on their salaries, and for OASDI and Medicare. They would also pay taxes on any distributions made in the form of dividends.

The corporation will pay taxes on its original net operating income LESS the salaries for Andy and Loren. It will also pay the employers' portion of the OASDI and Medicare taxes. Any benefits for Andy and Loren would be deductible expenses.

Andy's taxes when salary = $106,000

Income tax: $17,651 + (24% x [$106,000 - $103,350]) = $18,287

OASDI	$106,000 x 6.2%	=	$6,572
Medicare	$106,000 x 1.45%	=	$1,537
Total		=	$26,396

Loren's taxes when salary = $62,000

Income tax: $5,578.50 + (22% x [$62,000 - $48,475]) = $8,554

OASDI	$62,000 x 6.2%	=	$3,844
Medicare	$62,000 x 1.45%	=	$899
Total		=	$13,297/b>

Black Mesa taxes

The original net operating income can be adjusted for the following deductions for Andy and Loren's salaries and benefits:

Original net operating income:			$275,000
Andy's salary:		$106,000
Loren's salary:		$62,000
Benefits:		(500 x 12 x 2) $12,000
			$180,000
New net operating income			$95,000

Corporate tax is $95,000 x 21% = $19,950

FICA tax is $6,572 + $3,844 + $1,537+ $899 = $12,852

Adjusted net operating income = $62,198

This example has assumed that no distributions were made, so the only money taken out of the company by the owners was in salaries.

Scenario #2

If Andy and Loren decide to issue a qualified dividend in the amount of the adjusted net operating income. It could increase their income and their income tax over Scenario #1.

• Andy's share would be: $62,198 x 70% = $43,539.
  The additional tax is $43,539 x 0%* = $0
• Loren's share would be: $62,198 x 30% = $18,659.
  The additional tax is $18,659 x 0%* = $0

*There is no additional tax for Andy or Loren given that their dividend income falls within the 2025 capital gains 0% tax range. As a result, their taxes do not increase over Scenario #1.

The corporate income tax would remain the same as it was in Scenario #1 since dividends are taken out after taxes and not before.

Scenario #3

What if Andy and Loren decide they don't want to pay any corporate tax, and they grant themselves a bonus to cover the adjusted net-operating income ($95,000)? The bonus would increase Andy's compensation to $175,020 and Loren's to $91,580. This would increase the income taxes for the two, but the corporation would pay NO corporate income tax.

Andy and Loren would pay the following increase in Income and Social Security taxes:

Andy's taxes when Salary = $106,000; Bonus = $66,500 and Total Income = $172,500

Income tax: $17,651 + (24% x [$172,500 - $103,350])		=	$34,247
OASDI	$172,500 x 6.2%	=	$10,695
Medicare	$172,500 x 1.45%	=	$2,501
Total		=	$47,443

Loren's taxes when Salary = $62,000; Bonus = $28,500 and Total Income = $90,500

Income tax: $5,578.50 + (22% x [$90,500 - $48,475])		=	$14,824
OASDI	$90,500 x 6.2%	=	$5,611
Medicare	$90,500 x $ 1.45%	=	$1,312
Total		=	$21,747

Pros and cons

All 3 scenarios are possible if the company is organized as a C corporation. Each scenario has different advantages and costs:

• Scenario #1. In this scenario, Andy and Loren took a salary and left the rest of the earnings in the company. The company, Andy, and Loren each paid taxes. But the taxes didn't include any double taxation since they didn't declare any dividends. So it's the second lowest tax-wise of the 3 scenarios. Besides not having the money in their personal accounts, the main disadvantage would be if they accumulated so much in retained earnings that they became subject to the Accumulated Earnings Tax. (For more information on this tax, see DLC Course 42: Accumulated Earnings and Deferred Compensation.)
• Scenario #2. In this scenario, Andy and Loren declared a dividend. They ended up avoiding a double taxation scenario since their dividend distributions were not enough to meet the minimum capital gains tax rate of 15%. Had they had to pay taxes on their dividends, this would be the most expensive of the 3 scenarios.
• Scenario #3. In this scenario, Andy and Loren granted themselves a bonus to reduce earnings to zero, thus avoiding any corporate income tax. This scenario reduces the total taxation to that of the 2 shareholders, although personal income tax is increased by the amount of the bonus. This scenario works as long as the compensation paid to each of them is considered "reasonable" under IRS regulations and is the least expensive tax-wise.