316 Planning and Forecasting
The distribution to Morris beyond his reasonable salary would likely be
characterized by the IRS as a dividend to the corporation’s sole stockholder.
Since dividends cannot be deducted by the corporation as an expense, both the
corporation and Morris would pay tax on these monies (the well-known buga-
boo of corporate double taxation). A dollar of profit could easily be reduced to
as little as $0.40 of after-tax money in Morris’s pocket (Exhibit 11.1).
Knowing this, one might argue that the distribution to Morris should be
characterized as a year-end bonus. Since compensation is tax deductible to the
corporation, the corporate level of taxation would be removed. Unfortunately,
Congress has long since limited the compensation deduction to a “reasonable”
amount. The IRS judges the reasonableness of a payment by comparing it to
the salaries paid to other employees performing similar services in similar
businesses. It also examines whether such amount is paid as regular salary or as
a year-end lump sum when profit levels are known. The scooping up by Morris
of whatever money was not nailed down at the end of the year would surely
come under attack by an IRS auditor. Why not then put Victor on the payroll
directly, thus reducing the amount that Morris must take out of the company
for his family? Again, such a payment would run afoul of the reasonableness
standard. If Morris would come under attack despite his significant efforts for
the company, imagine attempting to defend payments made to an “employee”
who expends no such efforts.
Subchapter S
The solution to the unreasonable compensation problem may lie in a relatively
well-known tax strategy known as the subchapter S election. A corporation
making this election remains a standard business corporation for all purposes
other than taxation (retaining its ability to grant limited liability to its stock-
holders, for example). The corporation elects to forgo taxation at the corporate
level and to be taxed similarly to a partnership. This means that a corporation
that has elected subchapter S status will escape any taxation on the corporate
level, but its stockholders will be taxed on their pro rata share of the corpora-
tion’s profits, regardless of whether these profits are distributed to them.
Under this election, Morris’s corporation would pay no corporate tax, but Mor-
ris would pay income tax on all the corporation’s profits, even those retained
for operations.
EXHIBIT 11.1 Double taxation.
$1.00 Earned
−0.34 Corporate tax at 34%
0.66 Dividend
−0.25 Individual tax at 39.1%*
0.41 Remains
* Highest federal income tax rate in 2001.