The very nature of C Corp and S Corp business entities is to gross high profits. Placing their finances under the watchful eye of Federal and local tax agencies. Especially executive officer salaries which must follow the rules of reasonable compensation.
In this article:
- What is an executive officer?
- Corporate compensation for directors and executive officers
- C-Corp and S-Corp reasonable salary
- 60/40 rule for corporations
- How to file taxes for director and officer compensation
- Fringe benefits: non-taxable vs taxable examples
- Allowable compensation deduction for a publicly held company
What Is An Executive Officer?
An executive officer is a person who manages the day-to-day activities of a corporation. The 4 most common officers are a Chief Executive Officer (CEO), Vice President, Treasurer, and Secretary. Typically an officer will be chosen by a board of directors or shareholders.
Officers vs Board Of Directors
The board of directors, aka board members, oversees corporate affairs. They are elected to serve the mission of the shareholders. The main distinction between officers vs directors– officers are managed by the directors. They relay shareholder directives and decide what is reasonable compensation for executive officers.
Shareholders are owners of a corporation. They claim a stake in a company by exchanging personal assets for corporate shares. In turn, each owner shares a percentage of the corporation’s profit and losses.
Shareholders also have voting rights. They decide on corporate actions, board members, issuing new securities, and dividends. It is common for shareholders to wear dual hats as an officer and/or director. However, they must earn a reasonable salary as an officer.
Active vs Passive Ownership
Active owners invest in the business with capital and labor. They have a role in daily operating decisions and generally have more sway in votes about day-to-day activities. Passive shareholders have taken a step back and invest only capital. They do not work for the company but retain voting rights on high-level corporate initiatives. Both have ownership rights and receive distributions and/or dividends according to their ownership agreement.
C and S Corporations receive different forms of compensation. There are very clear rules about how each form of compensation should be taxed.
C Corp vs S Corp
C-Corporations are a company or group of people legally recognized as a separate entity from its owners. The corporation conducts business, realizes net income/loss, pays taxes, and distributes profits to shareholders. Owners of C Corps are subject to double taxation because both the corporation and the owner are taxed before and after dividend distribution.
C-Corps can hire at will as long as they maintain tax compliance and corporate business fees. If a corporation chooses not to hire employees, the IRS will assume a shareholder is acting as an officer for the corporation. Such an officer needs to be paid a salary, or the IRS will re-classify payments made to them as one.
Salary: a fixed annual amount of payment, subject to payroll taxes.
Distribution: a tax-free share of income, gain, loss, deduction, or credit.
Dividend: an amount of corporate profit given to shareholders and stockholders
Bonus: a reward payment made for efforts to further business objectives.
Stock Options: options to buy stock in the company at a set at a discounted price or free.
Shares Owned: own equity in the company, including all shareholder rights, voting rights, right to company dividends, right to company assets in the event of a sale.
Corporations or incorporated LLCs can make an S Corp election with the IRS. This is done to avoid double taxation by passing corporate income, losses, deductions, and credits through to shareholders. Then, shareholders report flow-through income/losses on personal tax returns and are taxed at individual income tax rates.
In an S Corp shareholders who are officers only pay self-employment taxes on salaries. Rather than the entirety of company profits. All other income is paid to shareholders in the form of tax-free distributions.
Shares vs Stock Options
Shares equal ownership in a company, stock options do NOT. If you have shares you have a say in the direction of the corporation. If you have stock in a company you are an investor with no ownership rights. Stock options are usually given as incentives to employees or officers. They are an option to buy NOT a right in the company. Stock options are subject to various conditions that may never be fulfilled. Options are usually held and exercised upon exit of the company.
How To Pay Corporate Directors Salary?
Usually, board members do NOT get paid a salary. When a director is hired outside of the company, they are paid an annual retainer and company stock. Corporate directors’ compensation needs to be reported for corporate income taxes. Their retainer fees cover organizing meetings, reviewing company filings, and obligations associated with overseeing the officers. Note: It is common for officers to serve as board members. When this happens, their responsibilities are often done without additional compensation.
How To Pay An Executive Officer Salary?
The IRS states that officers must receive reasonable compensation, but the rules on what counts as “reasonable” are vague. How do you determine what is reasonable and what is unreasonable compensation for your officer? Fair compensation should align with the Goldilocks principle. You can’t pay too little, you can’t pay excessive amounts.
Here are 9 items that determine reasonable compensation:
- The officers role in the organization
- Salary comparison of similar roles in different corporations
- Time and experience with the company
- Potential conflicts of interest
- Compensation agreements
- Use of formula to calculate compensation
- Payments to non-shareholder employees
- Bonuses, distributions, and/or dividend history of the corporation
- Consistency regarding compensation payments
What Is Unreasonable Compensation?
Corporate officer salaries are under an IRS magnifying glass. Unreasonable compensation at C and S Corporations comes in many forms. The IRS will penalize corporations for payment missteps. Here is what defines unreasonable compensation circumstances for C and S-Corps.
C Corp Constructive Dividends And Accumulated Earnings
Officers are closely monitored for excessive salaries. Examiners are looking for salaries that should be dividends. Why? If profit is disguised as payroll, they are missing out on additional tax via double taxation. A corporation is taxed on all profit that it cannot deduct as a business expense and payroll is a deductible expense. This is known as constructive dividends, where the IRS imposes a penalty and redistributes the compensation it deems excessive as a taxable dividend.
Some C-corporations try to bypass paying double taxation with retained earnings. A corporation is allowed to retain its profit to reinvest in the company. If an officer-shareholder doesn’t receive dividends, they don’t pay taxes on corporate profit. However, a company cannot have high retained earnings. Otherwise, an accumulated earnings tax is incurred, a penalty for not distributing dividends.
S Corp Reasonable Salary
Wage compensation for S corporation officers happens in three ways: a salary, a distribution (not subject to tax), and a dividend (subject to pass-through tax). When an officer is employed by the S Corp they cannot decline payment and must be paid a reasonable salary for employment. In addition, they can receive distributions and dividends if they are shareholders in the corporation.
Paying an officer a tax-free distribution without a salary is not legal. Underpayment is on the IRS radar because S Corps are NOT subject to double taxation like C Corps. The only taxes being collected are payroll taxes on salaries and pass-through taxes to shareholders.
The only time compensation is not required is if the corporation is not making money. Then an officer may elect to work for a corporation for free. This can only continue until the corporation can afford to pay a salary or hire an employee. If the S Corp expects to make money in the near future, they account for a deferred compensation plan for the officer. This prevents IRS scrutiny of a non-salaried officer suddenly hitting a windfall on the payroll.
Corporations Without Officers: 60/40 Rule
If a corporation elects not to hire an employee, they should follow the 60/40 rule. Technically it is not an IRS rule but many accountants put it to practice. The 60/40 rule applies to active shareholder distributions. Where 60% should be treated as a salary subjected to tax, 40% should be dividends. Note: this rule doesn’t apply to all circumstances and will not excuse you from a penalty if reasonable compensation is not followed.
Bonuses And Fringe Benefits Included Officer Compensation
Bonuses and benefits must follow reasonable compensation rules too. Paying an officer a reward should be based on performance, not just because there is extra profit. Corporations need to note performance indicators that qualify bonuses.
Here are examples of what constitutes performance-based benefits:
- Key Performance Indicators in the job agreement
- Time with the company
- Employee merits like education and training
Excessive Compensation Case Example
The U.S. Tax Court held Pediatric Surgical Associates (PSA) accountable for constructive dividends. They paid out bonuses to their shareholder-employees. Almost all of PSA’s net income was doled out in payroll, decreasing the amount of taxable income.
The issue is that the non-shareholder employees at PSA did NOT receive bonuses. Even though, the services performed by all employees were generally the same. More so, payroll was deducted as a business expense. The bonuses were reclassified as dividends and they suffered a penalty in the amount of 20% of the underpaid income tax.
Corporate Tax Filing For Compensation
C and S Corporations owe tax at the Federal and state level. States vary on corporate taxes, many charge franchise tax and have corporate fees. Remember: C Corporations are their own entity and pay taxes, while S Corporations pass-through tax to the shareholders. Here is how to file directors fees and officer compensation:
Tax Filing For Director Compensation
Directors hired from outside the company are issued a 1099-NEC for any fees over the annual threshold of $600. These payments are not considered officer compensation, and should never be subjected to payroll tax.
Tax Filing For Officer Compensation
Salaries go on payroll and are subject to Federal and state payroll taxes. If an officer is receiving a salary it is reported on a W-2.
- The corporation will expense officer compensation on Line 12 of Form 1120. If your company’s annual receipts total $500,000+ you must complete Form 1125-E.
- The officer will receive a W-2 reporting their salary, if they are a shareholder they get a 1099-DIV to report all corporate profit earnings.
- The corporation pays the employer portion of payroll taxes and reports it on Line 12 of Form 1120-S
- The officer will receive a W-2 reporting their salary, if they are a shareholder they also get a Schedule K-1 that reports corporation income/loss. Then all corporate income is reported on their individual tax return.
How To File An Executive Bonus
Bonuses are considered compensation so they are added to W-2’s and qualify for payroll tax deductions. They should not be used to get around paying double taxation on dividends. Bonuses are never tax-deductible when given as gifts, or dispersed without merit at the year-end or at the end of a contract term.
Corporate Fringe Benefits: Non-Taxable vs Taxable
Benefits given to officers are reported using W-2’s. Some benefits are taxable and some are non-taxable (tax-free). The IRS is very explicit on what is non-taxable. They will fine corporations and officers that disguise officer compensation as non-taxable fringe benefits.
Insurance: health insurance, accident insurance, disability insurance, group term life insurance coverage (limits apply)
Health Savings Accounts
Dependent care and educational assistance (limits apply)
Supplemental unemployment benefits
Qualified employee benefits plans: profit-sharing plans, stock bonus plans, and money purchase plans, employee stock options
Lodging at company-owned premises
de minimis (low-value) perks: special occasion gifts, event tickets, etc.
Clothing and uniforms
Bicycle commuting stipend
Awards and prizes
Excessive tuition reimbursement
Excessive mileage reimbursement
Private vs Public Officer Compensation
Private corporations are just that, private. They are not open to public investment on the stock exchange. In contrast, public companies can sell as much stock as they want, to public investors. Officer salaries are generally the same and must follow reasonable compensation rules. With the exception to one rule—officer compensation deductions for public corporations.
Publicly held companies typically earn more money from stock, pushing executive officer salaries higher. To curb excessive executive salaries, the IRS limits the allowable deduction of pay to employees. A public corporation cannot deduct more than $1 million annually in officer compensation per executive officer. This number is total compensation including salaries, bonuses, commissions, and other performance-based incentives.
Always Pay Reasonable Compensation
Officer compensation for corporations will always be under the gun. And such, reasonable compensation should always be handled with care. C and S Corporations must record all business decisions (or minutes) in meetings. For any compensation changes, detailed notes will be your saving grace if the government intervenes. We specialize in corporate tax filings, for all your Form 1120, or 1120-S needs.