IRS tells some execs they're getting paid too much — or too little

By Joyce M. Rosenberg
Associated Press

NEW YORK — The recent disclosures of huge pay packages for some prominent CEOs raise a question for small businesses as well: How much should the owner or top executives of a small firm be allowed to earn?

Technically, when you're the boss, you can draw whatever size paycheck you want. But if your business is a corporation, the amount of your compensation might be questioned by the IRS if it's too large — or too small.

Accountants say the IRS is paying closer attention to compensation amounts at companies known as S corporations, so they suggest owners in general be prudent about the salaries and bonuses they draw.

"They'll charge you penalties, and it'll be a nightmare," Richard Newman, a founder of Newman & Cohen Financial Management in Miami and Boca Raton, Fla., said of the IRS.

If you're a sole proprietor and file Schedule C along with your 1040, there are no limits on your compensation. The income from your business flows directly to you and is taxed along with your other personal income. Your banker will want to know what you take home if you apply for a loan, but there's really no one else you must answer to.

Similarly, in a traditional partnership, how the partners are compensated is entirely up to them. They're also taxed on their 1040s.

With corporations, problems arise when the government decides that an owner or top executive is earning too much or too little, depending on whether the company is what's known as a C corporation or an S corporation. Both names come from the Internal Revenue Code.

In the more traditional C corporation, the company itself is taxed on what it earns, and when earnings are paid out to shareholders as dividends, the shareholders are also taxed on that income. (This is what's known as double taxation).

Compensation problems arise in C corporations when an owner or top executive is overpaid by IRS standards. Compensation is tax-deductible to the corporation, and it also reduces the amount of money payable as dividends to shareholders (lowering the double taxation burden). The IRS looks to see if a company is trying to skirt some of these taxes through big compensation.

In an S corporation, the company's earnings are not taxed. They're instead "passed through" to shareholders, who pay individual taxes on the income.

With an S corporation, the issue is that owners might take too little in pay. The government's concern is that companies might be trying to avoid payroll taxes, which are levied on compensation but not dividends.

Whether you have a C corporation or an S corporation, the IRS will look at what is a reasonable salary for an owner or top executive of a company in a given industry and a given geographic area.