A common problem for family-owned corporations involves compensation. The Tax Code allows the corporation to deduct "reasonable" compensation. Pay too much, and the IRS might re-characterize the excessive compensation as a non-deductible dividend. Pay too little and the IRS may assess penalties and interest for underpaying employment taxes.
A common example: mom and dad own the business but their three sons run it. Their daughter is listed as a corporate officer but does not provide services to the company. She receives payments equal to her brothers, in order to avoid hurt feelings. Since she provides no services, all of the payments are nondeductible, taxed at the corporate level (at corporate rates) and again taxed to daughter personally.
When considering how to compensate family members, keep in mind several things:
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Compensation is payment for the value of services rendered to the corporation. If someone is not providing services, they should not receive compensation. Those family members providing services should be paid the fair value of those services, not based upon ownership interests, relationships, or other factors unrelated to their service.
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Document compensation arrangements with written employment agreements signed at the beginning of a fiscal year (or that cover several years in advance). The agreement should describe the services provided and the compensation (both in cash and benefits) paid for such services.
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When making changes to compensation arrangements of corporate officers or executives, document the reasons for the change and the new amount in the minutes of the Board, then update the written agreement.
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Avoid large year-end bonuses, especially those based on a percentage of corporate profits, which looks very similar to a dividend. Instead, use larger salary amounts, and base bonuses on stated performance metrics and the recipient's salary.
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Consider electing S corporation status, which entirely eliminates the corporate-level income tax concerns. Since taxes accrue and are paid only at the individual level, electing S corporation status eliminates the income tax distribution versus compensation issue (although it may still exist for employment tax purposes).
In our example above, since the sister does not work for the corporation and is not an owner, she cannot receive either compensation or distributions. If the goal is to provide income to the sister, that will require she provide services to the corporation (perhaps as a Board member, if not as an employee) or become a shareholder entitled to dividends.
