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When business is good and sales are pouring in, life couldn't be better--except when it comes to taxes. Because now, of course, you're shelling out more to the IRS and keeping a smaller slice of that hard-earned cash for yourself. The good news is there are ways to reward yourself and your employees that can actually save you money in taxes. And it's not just during a boom that it's helpful to look at your compensation arrangements to make sure your strategy makes the most sense taxwise. When it comes to tax dollars, any time is the right time for a checkup.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.
Watch Your Step
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.
Winning With Incentives
As you review your compensation options, you may want to make greater use of a long-term incentive plan, such as stock options, phantom stock or other types of deferred compensation arrangements. In recent years, these long-term incentive plans have assumed a larger role in companies' compensation packages because they not only have tax advantages, but they help retain key executives and managers.
For regular corporations, stock options in particular have become a very popular strategy. When stock options are offered, executives, managers or even regular employees are given the option of purchasing the company's stock in the future at the prices set when the options are granted. If the price of the stock increases, the recipients benefit because they can buy low and sell high.
"Stock options have really come to the forefront in the past 10 years because of the marketplace,' says Rebecca Autry, a manager with accounting firm Grant Thornton LLP in Cincinnati. "Because of the labor shortage, business owners are trying to attract and retain quality people, and [stock options are] one of the mechanisms used to achieve that."
The tax benefits of issuing stock options are particularly good. "The company records no expense for providing compensation through stock options, plus it gets a tax deduction for providing compensation that way,' says Christopher Rich, president of Lyons Compensation & Benefits LLC in Waltham, Massachusetts.
There are essentially two types of stock options: nonqualified options and incentive options (ISOs). Nonqualified options represent the bulk of options issued today. They trigger ordinary income tax on the appreciation captured when individuals exercise the options.
For example, if an employee receives an option to purchase a company's stock at $10 per share, and after several years, the current fair market value increases to $15 per share, the $5 appreciation is compensation to the recipient and is taxed as income. This amount is also subject to Social Security and Medicare taxes. The $5 increase is deductible by the company as a compensation expense. Of course, instead of buying and selling, the employee can choose to hold the stock, which may continue to increase in value.
The tax basis for calculating future stock gains is the market value of the stock at the time the option was exercised. Only appreciation of the stock above that level is taxed when the recipient decides to sell the stock. If he or she holds it for more than a year, the profit will be treated as a long-term capital gain, which is subject to a maximum 20 percent tax rate.
When recipients sell stock gained through ISOs, on the other hand, the options are taxed at capital gains rates rather than the higher tax rates that apply to ordinary income. There is no taxation at grant or at exercise. There are, however, certain restrictions on the terms of an ISO and how long it must be held. Autry points out that from a company perspective, ISOs are not as favorable taxwise as nonqualified options because of the various rules governing them.
Both types of options have no cash value when they're given out because they can't be converted to cash or stock until they vest. The time it takes to vest depends on the requirements of each plan, but it generally ranges from two to five years.
For the most part, stock options work best with public corporations and have less of a role with S corporations and limited liability companies (LLCs), Autry says. Why? Because owners of closely held S corporations and LLCs aren't usually as interested as public corporations are in giving away ownership.
A Phantom Variety
For companies organized as S corporations or LLCs, there are other strategies available, but for the most part, they don't offer any real tax benefits. For example, owners of closely held companies can use phantom stock arrangements or stock appreciation rights rather than issuing actual stock. Phantom stock has the property of stock, but it isn't actual stock and therefore, doesn't represent actual ownership, Powell explains.
At a later date, when the employee retires, becomes disabled or dies, the phantom stock can be converted to either actual stock or cash, based on the stock's fair market value. The plan can define the stock's fair market value as book value--value based on a prescribed formula or value based on an appraisal--according to Powell. Generally, the conversion will be on the gain on the stock, rather than the stock's complete value.
Unfortunately, awarding phantom stock isn't currently deductible as a business expense for the company until the employee reports its income. For the employee, there's no economic benefit until a conversion date, such as retirement, is reached. In addition, he or she isn't required to pay income tax until the stock is converted or sold; however, the corporation must record the phantom stock award on its financial statement, indicating a future liability, says Powell.
Rich believes business owners should consider alternatives to phantom stock. A good one is something called a performance plan. Under such a plan, a company creates a "performance unit" with value tied to the earnings of the company, says Rich. The business owner could award top executives, managers or employees a specific number of these units. If the company grows, the units owned by the employees will appreciate regardless of whether the owner takes earnings out of the company because the units are based on earnings before distribution of profits.
When using performance plans, there are negative tax consequences in the short term to the owners of closely held businesses because they can't take a tax deduction for the amount set aside, Rich points out. "They don't get one until the benefits are paid out at a later date," he says.
While standard pay arrangements are fairly straightforward as far as their deductibility as business expenses are concerned, don't neglect to consider the various tax aspects of some of the other pay and compensation strategies that are now gaining a greater role in today's marketplace. No matter which strategy you select, your aim should be to keep more for yourself and pay less to the IRS.
David Berdon & Co. LLP, 415 Madison Ave., New York, NY 10017, (212) 832-0400
Grant Thornton LLP, 625 Eden Park Dr., #900, Cincinnati, OH 45202, (513) 762-5000
Lyons Compensation & Benefits LLC, Watermill Ctr., 800 South St., #660, Waltham, MA 02453, (781) 647-5700