When the profits are flowing in, it's often tempting to give yourself a nice, big bonus at the end of the quarter. But you'd better keep your greed at bay if you're organized as a regular corporation: The IRS is going after those business owners who pay themselves too much.
A number of entrepreneurs have ended up in court on the issue, and the IRS has come away with some impressive wins. It has successfully argued that a portion of the compensation taken, including bonuses, should have been declared corporate dividends. When dividends are declared, the owner is taxed twice on the income, once at the corporate level and again when the owner receives the money.
As you know, compensation is considered a business expense and deductible. To be deductible, however, the IRS maintains that those salaries and wages must be ordinary and necessary, as well as reasonable. Red flags often go up, say tax experts, when the IRS sees profits increasing and the owner spiking his or her own salary and bonus excessively.
To decide whether compensation is reasonable, the IRS looks at a number of factors. These include the nature and size of the business, the nature and scope of the work the owner does at the company, the amount of time required for the services, and any special qualifications the owner has. Industry surveys and third-party studies help determine what is considered reasonable compensation for companies in the industry.