Tom Talks Taxes - November 12, 2021
Reconsider "zeroing" out a C corporation with a bonus
We’ve entered tax planning season and it is time to consider year-end shifts and changes. Many taxpayers and tax professionals alike try to avoid the potential double taxation inherent in a C corporation by paying a year-end bonus to a shareholder-employee, thus reducing or eliminating cash in the corporation not needed for operations.
By doing this, there is a single level of tax paid on that distribution at the shareholder level as wage income. If the same amount is paid as a dividend, it is subject to tax at both the C corporation level and at the shareholder level, since dividends are not a deductible expense to the corporation.
However, there are two major problems with this strategy:
A taxpayer often pays more overall tax on a bonus when compared to retaining the money and paying a modest dividend, and
The total compensation paid to the shareholder-employee may not be reasonable compensation, creating a compliance issue.
Let’s illustrate the first problem with an example. Donna is in the 37% tax bracket and is an employee of her own C corporation. On the advice of her accountant, she gives herself a $200,000 bonus each year to zero-out the C corporation, so that she pays no entity level tax.
Donna pays $81,600 in federal taxes on that bonus:
$74,000 in federal income tax (37% of $200,000), and
$7,600 in Medicare and Additional Medicare Tax (3.8% of $200,000).
If Donna did not pay the bonus, she would pay $42,000 in C corporation federal income tax on that amount (21% of $200,000), saving her $39,600. Donna will also pay $238 in federal income tax for every $1,000 she distributes as a dividend (23.8% of $1,000).
Let’s say Donna has $140,000 remaining after paying federal and state taxes on the $200,000 (remember, state taxes are fully deductible in the C corporation and reduce the amount available for distribution). If she takes a $100,000 dividend, then she will pay $23,800 in federal income tax on that dividend. Taking a significant dividend still leaves Donna with $15,800 in federal tax savings compared to paying a bonus.
We also need to consider state taxes in this determination. For example, in California, Donna pays a lower rate inside the C corporation (8.84%) versus an individual (10.3% or more) on both wage and dividend income. In some states, there may be a corporate-level tax, but no individual income tax. State tax implications cannot be ignored.
The above math also applies for taxpayers with lower income levels and smaller C corporations, especially if the bonus is subject not only to Medicare tax but also Social Security tax.
For the second problem, the C corporation reasonable compensation issue is the opposite of that for the S corporation: the corporation overpays salary to its shareholder-employee to avoid double taxation via dividends. If the total compensation paid is not reasonable, then the IRS or the courts can disallow the corporation deduction and reclassify the bonus as a taxable dividend to the shareholder. Treas. Reg. §1.162-7(b)(3) states:
…the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances…
Each Circuit Court of Appeals has a different test for C corporation reasonable compensation determinations. Under the Golsen Rule, the Tax Court will apply the precedent of the circuit to which the taxpayer has the right to appeal.
For example, from Elliotts v. Comm., 716 F2d 1241 (9th Cir. 1983), the Ninth Circuit looks at the following five factors equally:
The employee's role in the company,
A comparison of compensation paid by similar companies for similar services;
The character and condition of the company,
Potential conflicts of interest, and
The internal consistency of compensation arrangements.
On the other hand, the Seventh Circuit adopted an "independent investor" test in Exacto Spring Corp. v. Comm., 196 F.3d 833 (7th Cir. 1999), under which the court determines if an independent investor would be willing to compensate the employee as he was compensated.
There are, of course, several other factors to consider, including the extent the C corporation can and should retain earnings for the reasonable needs of the business as well as the taxpayer’s overall need for cash for living and personal needs.
The key takeaway is that a bonus strategy often produces suboptimal tax results and puts the taxpayer at risk of IRS reclassification. The best solution is one that looks at the totality of both the individual’s and C corporation’s tax situation and comes up with a proactive strategy, not one that is a quick year-end fix to a perceived problem.
If you are interested in learning more about C corporation tax planning, join me on December 2, 2021 for a 2 CE/CPE webinar on C Corporation Tax Planning.
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