There are some steps you should never take unless you want an IRS agent showing up on your doorstep in short order. For example, if your company is organized as a regular corporation, don't award pay increases that double your salary or that of a top manager who also happens to be a shareholder. This is sure to cause IRS scrutiny. To be deductible as business expenses, the IRS says, salaries and wages paid must be ordinary and necessary, as well as reasonable.
The tax agency pays especially close attention to the "reasonableness" of a salary if it's the owner's. Generally, questions will arise if profits skyrocket and the owner boosts his or her own salary to an excessive level in an attempt to not declare dividends, says Kenneth Powell, a tax partner with accounting firm David Berdon & Co. LLP in New York City.
The IRS recognizes reasonable pay as the amount businesses typically pay for services performed at similar companies under similar circumstances. If pay is excessive, the company can only deduct the amount that's considered reasonable by the IRS. The excess is treated as a dividend. As a dividend, the payment can result in an increase in the corporation's taxable income in the year the payment is made. The shareholder owner will also have to pay a corporate income tax on the dividend.
In determining whether pay is reasonable, the IRS looks at the nature and size of the business claiming the deduction, the nature and scope of the work the individual has done for the company, the amount of time required for the services, any special qualifications the individual has, the history of pay for each employee, and the complexities of the business. The IRS can justify reviewing your company's salary records whenever it becomes suspicious about salary deductions you file on your annual corporate tax return.
Instead of increasing salaries, you may want to look at some of the other compensation arrangements available and their corresponding tax impacts. Some options you should consider giving more emphasis to include bonuses, stock options or other deferred compensation arrangements. Some of these may represent tax-beneficial ways to pay yourself and your top managers.
While the annual bonus is a typical component of compensation for many businesses, remember that an excessive cash bonus can also set off IRS suspicion because the tax agency may think you're using it as a way to disguise a distribution of profits. If this is the case, the payment isn't deductible as a business expense by the company; the IRS requires that it be taxed as corporate income. The upshot? Your business ends up paying more in corporate income taxes.