S-Corporation

WHAT IT IS

An S-corporation[1]  (S–corp) starts out as a C–corporation (C-corp) incorporated under a state business corporation statute that then elects to be treated as a pass through tax entity under the Internal Revenue Service (IRS). [2]  All shareholders must consent to the S-corp election.

An S-corp offers limited liability, a corporate management structure and state corporate formality requirements, but instead of the C-corp’s separate entity taxation, the S-corp’s income, losses, deductions, and credits pass through the entity to the shareholders, and are taxed only once at the shareholder level.  S-corp shareholders report their income, losses, deductions, and credits on their personal tax returns.  S-corp income is taxed at the shareholders’ personal income tax rates.

An S-corp is defined by the IRS as a “small business corporation”[1].  “Small” in the case of an S-corp does not refer to asset size, number of employees, or industry presence.  This is not a “small business” as defined by the U.S. Small Business Administration (SBA).  The SBA defines small businesses as not dominant in their fields and limited in number of employees or annual receipts. [3]  This is different.  S-corps may have unlimited receipts and assets, unlimited employees, and unlimited field presence.  “Small” in the case of an S-corp refers strictly to corporate ownership; shareholder number (100 maximum) and restricted shareholder eligibility (below).

WHO CAN DO THIS:

Only domestic corporations with a maximum of one hundred (100) eligible shareholders may make the S–corp election.  Foreign corporations may not become S–corps.  Insurance companies and certain financial institutions [4] may not become S-corps.

All shareholders must be individual U.S. citizens or residents, certain tax-exempt organizations, [5] certain trusts, [6] or estates (during their normal estate administration periods). [7]  Family members may be counted as a single shareholder, but each family member must be an eligible shareholder in their own right.

Partnerships, corporations, and nonresident individuals are not eligible S-corp shareholders.

Transferring S–corp shares to ineligible shareholders will defeat S–corp status.

Certain states may require that incorporators (those who organize a corporation) meet certain age requirements or other qualifications.

Individuals serve as S-corp directors and officers. Some states may also have director age restrictions or other qualifications.

Every corporation must generally have officers.  Typically, one individual may serve multiple offices.

Directors and officers generally do not have to be shareholders.  (The very idea of the corporation has to do with dividing these roles.)  Nonetheless, any one or more individuals may generally form a corporation and serve all necessary corporate positions.  For example, a single individual may serve as sole shareholder, sole director, and sole officer.  However, especially where corporate owners are also directors or officers, it is important that owners respect the corporate form.  To maintain limited liability, corporate shareholders, directors, and officers must clearly treat the corporation as an entity separate and distinct from themselves and treat the different roles as separate and distinct from each other.

WHO HANDLES WHAT:

Shareholders own the business and elect directors.  Shareholder approval may be required for certain decisions.

The board of directors directs and manages the business and its affairs, and elects or appoints any officers.

The board of directors itself may have officers, such as a president of the board or board secretary. In general, though, the idea of corporate officers refers to operational or executive officers, who may be elected or appointed by the board to execute day-to-day operations under board direction.  (A corporation may have board officers and operational officers.  Board officers are directors and are liable as managers (more below).  Operational officers who are not on the board are not liable as managers.)

TO WHOM YOU ARE RESPONSIBLE:

Shareholders, directors, and officers are generally not personally liable for the corporation’s obligations.  Thus, shareholders’, directors’, and officers’ personal assets are not generally reachable by the corporation’s creditors or others to whom the corporation may be liable.  Shareholders generally have no liability risk beyond the price paid for their shares.

(Warning:  Where parties personally guarantee a debt or obligation, they cannot avoid personal liability for such guarantee.)

Limited liability rests on the valid existence of a separate and distinct entity.  Thus, in spite of their general limited liability, shareholders may be held personally liable for acts carried out in the corporate name before the corporation is formed, in cases of defective incorporation, or in cases in which the corporate veil is pierced because the corporation is not treated by its participants as separate and distinct.

Directors are generally liable to the corporation and to shareholders for managerial decision-making.  Corporate directors are in a position of trust and confidence, and therefore generally owe fiduciary duties of loyalty and care to the corporation.  Under the duty of loyalty, directors must act in the corporation’s best interests, in spite of any conflicting self-interest.  Directors must refrain from doing anything that would injure the corporation or deprive it of any profit or advantage.  Directors must not usurp corporate opportunities.

Under the duty of care, directors must carefully consider all material information in making business decisions.  Directors must not act with gross negligence or reckless indifference to, or fail to act in light of, the available information.

When considering board decisions, courts generally apply the “business judgment rule” when possible to respect the board as ultimate business manager, and to presume that board decisions are informed, made in good faith, and made under belief of the corporation’s and shareholders’ best interests.  (This is not the case if there is evidence of director fraud, bad faith, or self-dealing.)

In most states, directors generally have an implied duty of good faith and fair dealing in carrying out their corporate rights and responsibilities and in carrying out the terms of any agreement.

Per state law, and depending on corporate structuring, shareholders and officers may owe fiduciary or good faith duties.

In most states, all parties who enter into contracts have an implied contractual duty to carry out the terms of any contract in good faith and with fair dealing.

The corporation is liable for its debts, obligations, and liabilities to clients, customers, creditors, and anyone who incurs injury as a result of its goods or services, or wrongful or negligent actions.

The corporation and all participants are responsible for complying with any and all applicable laws, rules, regulations, procedures.

YOUR POWER TO AFFECT THE BUSINESS STRUCTURE

An S–corp may have only one (1) class of stock, with no differences in income or distribution entitlements, but within that single class there may be voting and nonvoting shares.

Other than tax, ownership size and shareholder eligibility, S-corp structuring is identical to C-corp structuring in that it consists of a three-tiered, corporate structure made up of directors, officers, and shareholders.

HOW LONG YOUR BUSINESS LASTS

An S – corp may exist in perpetuity.

How You Get Paid

Shareholders may receive equity distributions.  Shareholders who are also officers may receive employee compensation for their officer-employee services.

Officers are generally employees, and receive employee compensation. [8]

Directors may receive compensation for director services as independent contractors, not employees, but this is not generally applicable in a small, closely held corporation. [9]

Directors who receive director services compensation and are also officers or shareholder employees may receive compensation that is in part independent contractor compensation, and in part employee compensation. [10]

ACCOUNTING

Your S-corporation may use a cash, accrual, special, or hybrid accounting method that clearly reflects the business’s income and expenses. [11]

Taxes

An S-corp generally does not pay its own taxes (although it may be taxed on certain built-in gains and passive income). [12]  The character of S–corp income, losses, deductions, and credits are determined and reported at the entity level, and the corporation files an informational return.  Income and other items pass through the entity and are taxed to the shareholders at the shareholders’ personal tax rates.  Shareholders include their pro-rata shares of the business’s income and losses on their personal returns.

Officer compensation is subject to payroll taxes (paid in part by the entity, and in part by the employee), but profit distributions over and above reasonable employee compensation are not subject to payroll tax.  (Ex: S-corp earns $100,000 in revenue.  Officer employee receives $70,000 in reasonable employee compensation, and that same person receives $30,000 in profit distributions as a shareholder.  The $70,000 officer compensation is subject to payroll tax, the $30,000 in shareholder distributions is not.)

The IRS realizes that S–corps may attempt to re-characterize officer compensation as profit distributions in an effort to wrongfully avoid payroll taxes. [13]  To pass muster with the IRS, officer compensation must be reasonable. [14]  While the IRS seeks to ensure that C-corp officer compensation is not artificially high to avoid the double dividend tax, it seeks to ensure that S-corp officer compensation is not artificially low to avoid payroll tax.

W2 wages to officers may vary, but any shareholder profit distributions must be allocated pro-rata per ownership percentage.  No special allocations are allowed.

The costs of certain fringe benefits (notably, health insurance) must be included in the employee wages of shareholder-officers owning more than two percent (2%) of the corporation.

The shareholder’s ability to deduct S-corp losses is limited to the shareholder’s basis in the corporate stock and any indebtedness the corporation owes to the shareholder.  Other corporate debt is not included in shareholder basis.

An S-corp is generally eligible for tax-free merger with another corporation. [15]

ANNUAL STATE BUSINESS FILINGS AND FORMALITIES

S-corporations must generally file annual reports with the Secretary of State and pay required annual fees.  Additional filings may be required, such as upon events like changes in issued shares or paid in capital, or merger or consolidation.

Your corporation must generally hold at least one annual shareholders’ meeting or record a written consent in lieu of a meeting, and shareholders must receive proper notice of any meetings.  Your state may require that shareholders receive notice in writing a specific number of days before particular meetings.

Your state may require at least one annual board meeting or written consent of the directors in lieu of a meeting.  Directors must generally hold regular meetings to carry out managerial business and record meeting minutes, resolutions, and all board actions, and maintain these corporate records.

Your corporation must have and maintain certain corporate books and records and make these reasonably available to shareholders.  Certain books or records may be required to be available at shareholders’ meetings.

NOTEWORTHY

An S-corp may be a good choice if your business will benefit from corporate structuring and third party familiarity, but does not require broad-based shareholder financing.  Pass through taxation and no FICA withholdings on proper post-compensation distributions are advantageous, but an S-corp also has some tax disadvantages when compared to LLCs that are disregarded (taxed like sole proprietorships) or taxed as partnerships.  While S-corp profit distributions are considered pass-through income for purposes of the potential twenty-percent (20%) available tax deduction under IRC Section 199A [16], S-corp officer compensation is not. But, all LLC disregarded entity income and partnership income is pass-through for 199A purposes. Additionally, although all such LLC member income is subject to FICA, the S-corp does not allow special allocations while the partnership-taxed LLC does, and unlike the LLC, S-corp shareholder basis does not include general corporate debt.  As such, if you expect your business to incur start-up losses, greater loss deductions may be available for LLC members than S-corp shareholders.  Additionally, transfers of property to an S-corp in exchange for ownership are only tax-free if immediately after the transfer the transferor controls eighty percent (80%) or more of the corporation’s total voting power.  LLC member contributions made in exchange for membership interest are generally tax-free regardless of ownership percentage, or whether made upon formation or over the life of the entity. Additionally, distributing appreciable assets that have increased in value over time in a corporation may involve costly tax consequences, while distributing appreciated assets out of an LLC that is disregarded or taxed as a partnership typically does not result in tax consequences.

Depending on your circumstances, an S-corp may be a good business form. It is important to consider all factors relevant to choice of entity. Click here to learn about Choice of Entity consult.

[1] I.R.C. § 1361 (1986); http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations.

[2] I.R.C. § 1362 (1986).

[3] http://www.sba.gov/content/what-sbas-definition-small-business-concern.

[4] Financial institutions that use the reserve method of accounting for bad debts are not eligible to become S-corps.  I.R.C. § 1362(b)(2) (1986).

[5] Tax exempt 401(a) and 501(c)(3) organizations may be S-corp shareholders.  I.R.C. § 1361(c)(6) (1986).

[6] Grantor trusts, qualified subchapter S trusts (QSSTs), electing small business trusts (ESBTs), voting trusts, qualified revocable trusts for a reasonable estate administration period, for a limited period- trusts created under estates, under certain acts of law- custodial arrangements of certain foreign trusts, tax-exempt retirement plan trusts.  I.R.C. § 1361 (1986).

[7] I.R.C. § 1361 (1986).

[8] See I.R.C. §§ 3121 (d)(1), 3306 (i), and 3401 (c) (1986).

[9] I.R.S. Pub. 15-A, Employer’s Supplemental Tax Guide 5 (2013), available at http://www.irs.gov/pub/irs-pdf/p15a.pdf.

[10] See Rev. Rul. 58-505, 1958-2 C.B. 728.

[11] I.R.S. Pub. 542, Corporations 8-9 (2012), available at http://www.irs.gov/pub/irs-pdf/p542.pdf.

[12] http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations.

[13] See Rev. Rul. 74-44, 1974-1 C.B. 287; I.R.S. Info No. 2003-0026 (2003).

[14] See Renewed focus on S Corp. Officer Compensation, AICPA Tax Division’s S Corporation Taxation Technical Resource Panel, Tax Advisor 280 (2004), available at http://www.thefreelibrary.com/Renewed+focus+on+S+Corp.+officer+compensation.-a0116671220.

[15] J.C.T., Selected Issues Relating to Choice of Business Entity 29 (2012).

[16] https://www.law.cornell.edu/uscode/text/26/199A; https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs


C-corporation[1]

WHAT IT IS

A C-corporation (C-corp) is the classic regular corporation that has not made an S-corp tax election. [2] (See below for information on S-corporations.)

The basic idea of a corporation is about division between ownership, management, and conduct.  The idea here is that in breaking apart the various parts of the business, we also separate and limit participants’ rights, responsibilities, and liabilities, and can narrowly shape each tier of participation.

Separating ownership from management means that ownership can be splintered off into numerous shares; helping the business to efficiently raise broad-based capital while distributing and minimizing investors’ financial risk.  Management can remain relatively centralized.

A corporation, formed and maintained properly, provides limited liability.  None of the participants are personally liable for corporate obligations.  Managers (directors) are generally liable to the corporation and its shareholders for management decisions.

Shareholders own the business and elect managers (a board of directors).

Directors control business direction, and may appoint or elect officers.

Officers generally execute daily business operations under the board’s direction.  (Certain directors may also serve as officers of the board if they hold board offices, such as president of the board.)

Although a corporation may require group decision-making, this is more of a hierarchy than a true democracy.

WHO CAN DO THIS:

Certain states may require that incorporators (those who organize a corporation) meet certain age requirements or other qualifications.

Any individual or entity may be a shareholder in a C-corp.  Shares are generally freely transferable subject to federal and state law, the corporate bylaws, and any shareholders agreement.

Individuals serve as directors and officers.

There must generally be one or more directors.  This may vary by state.  Some states may also have director age restrictions or other qualifications.

Every corporation must generally have officers.  Your state may require your corporation to have certain officers.  Typically, one person may hold two or more offices.

Directors generally do not have to be shareholders.  (The very idea of the corporation has to do with dividing these roles.)  Nonetheless, any one or more individuals may generally form a corporation and serve all necessary corporate positions.  For example, a single individual may serve as sole shareholder, sole director, and sole officer.  However, especially where corporate shareholders are also directors or officers, it is important that shareholders respect the corporate form.  To maintain limited liability, corporate shareholders, directors, and officers must clearly treat the corporation as an entity separate and distinct from themselves and treat the different roles as separate and distinct from each other.

WHO HANDLES WHAT

Shareholders own the business and elect directors.  Shareholder approval may be required for certain decisions.

The board of directors directs and manages the business and its affairs, and elects or appoints any officers.

The board of directors itself may have officers, such as president of the board or board secretary. In general, though, the idea of corporate officers refers to operational or executive officers, who may be elected or appointed by the board to execute day-to-day operations under board direction.  (A corporation may have board officers and operational officers.  Board officers are directors and are liable as managers (more below).  Operational officers who are not on the board are not liable as managers.)

TO WHOM YOU ARE RESPONSIBLE

Shareholders, directors, and officers are generally not personally liable for the corporation’s obligations.  Thus, shareholders’, directors’, and officers’ personal assets are not generally reachable by the corporation’s creditors or others to whom the corporation may be liable.  Shareholders generally have no liability risk beyond the price paid for their shares.

(Warning:  Where parties personally guarantee a debt or obligation, they cannot avoid personal liability for such guarantee.)

Limited liability rests on the valid existence of a separate and distinct entity.  Thus, in spite of their general limited liability, shareholders may be held personally liable for acts carried out in the corporate name before the corporation is formed, in cases of defective incorporation, or in cases in which the corporate veil is pierced because the corporation is not treated by its participants as separate and distinct.

Directors are generally liable to the corporation and shareholders for managerial decision-making.  Corporate directors are in a position of trust and confidence, and therefore generally owe fiduciary duties of loyalty and care to the corporation.  Under the duty of loyalty, directors must act in the corporation’s best interests, in spite of any conflicting self-interest.  Directors must refrain from doing anything that would injure the corporation or deprive it of any profit or advantage.  Directors must not usurp corporate opportunities.

Under the duty of care, directors must carefully consider all material information in making business decisions.  Directors must not act with gross negligence or reckless indifference to, or fail to act in light of, the available information.

When considering board decisions, courts generally apply the “business judgment rule” [3] when possible to respect the board as ultimate business manager, and to presume that board decisions are informed, made in good faith, and made under belief of the corporation’s and shareholders’ best interests.  (This is not the case if there is evidence of director fraud, bad faith, or self-dealing.)

In most states, directors generally have an implied duty of good faith and fair dealing in carrying out their corporate rights and responsibilities and in carrying out the terms of any agreement.

Per state law, and depending on corporate structuring, shareholders and officers may owe fiduciary or good faith duties.

In most states, all parties who enter into contracts have an implied contractual duty to carry out the terms of any contract in good faith and with fair dealing.

The corporation is liable for its debts, obligations, and liabilities to clients, customers, creditors, and anyone who incurs injury as a result of its goods or services, or wrongful or negligent actions.

The corporation and all participants are responsible for complying with any and all applicable laws, rules, regulations, procedures.

YOUR POWER TO AFFECT THE BUSINESS STRUCTURE

Most states’ business corporation statutes include numerous “default rules” regarding internal corporate governance, such that there is less wiggle room to modify the corporate form than there is with, for example, an LLC.  Yet within the corporate structure, every corporation is unique.

C-corporations can involve ownership structures with varying share designations, preferences, rights, and interests.  They can specify reasonable share transfer restrictions to define who may be an owner of the corporation. They can determine director and officer qualifications, rights, and responsibilities (as can S-corporations).

The details of the C-corporation’s structure and internal rules are typically defined by a combination of state law, the corporate bylaws, and any applicable shareholders agreements.

HOW LONG YOUR BUSINESS LASTS

A C-corporation may continue to exist indefinitely, regardless of changes in ownership or management.

HOW YOU GET PAID

Officers are generally employees, and receive employee compensation. [4] Shareholders who are also officer-employees receive W2 employee compensation for their services as officers.

Shareholders may receive dividends (profit distributions of corporate after-tax earnings).

Directors may receive compensation for director services as independent contractors, not employees, but this is not applicable in a small, closely-held corporation. [5]

Directors who receive director services compensation and are also officers or shareholder employees may receive compensation that is in part independent contractor compensation, and in part employee compensation. [6]

ACCOUNTING

A C-corporations may use a cash, accrual, special, or hybrid accounting method that clearly reflects the business’s income and expenses. [7]

TAXES

Corporations pay their own income tax at corporate tax rates.  A C-corporation will be responsible for federal income tax/estimated tax, and any applicable employment and excise taxes. [8]

If the corporation distributes dividends/profits to shareholders, these come out of its after-tax earnings and profits.  Shareholders must then pay personal tax on those dividends.  Because both the corporation and shareholders pay tax on the same income, this is often referred to as a double tax.

The corporation may deduct normal business expenses, including “reasonable” compensation paid to officer-employees. [9] The IRS is keen to, and may re-characterize, officer compensation of individuals who are also shareholders when that compensation is artificially inflated to allow the corporation to wrongfully avoid properly characterizing dividends/profit distributions. [10]

Corporations may deduct the costs of certain fringe benefits provided to employees, may exclude from income or defer certain gains, and may treat certain losses as net operating losses; carrying them forward or back. [11]

The corporation is taxed on the gain received upon sale of appreciated assets.

Corporations may generally elect to use a calendar or fiscal year.

To accomplish tax-free transfers of property in exchange for ownership, the transferor must own at least eighty percent (80%) of the corporation’s total voting power immediately after the transfer.

ANNUAL STATE BUSINESS FILINGS AND FORMALITIES

Corporations must generally file annual reports with the Secretary of State, and pay required annual fees.  Additional filings may be required upon certain events, such as changes in issued shares or paid in capital, or merger or consolidation.

Typically, a corporation must generally hold at least one annual shareholders’ meeting or record an annual written consent in lieu of a meeting, and shareholders must generally receive proper notice of meetings.

A corporation typically requires at least one annual board meeting or written consent of the directors in lieu of a meeting.  Directors must generally hold regular meetings or record written consents to carry out managerial business, and should record meeting minutes, resolutions, and all board actions, and maintain these corporate records.

A corporation is required to have and maintain certain corporate books and records, and to make certain of these reasonably available to shareholders.  Certain books or records may be required to be available at shareholders’ meetings.

NOTEWORTHY

Corporate case law is well-developed, and the corporate form is likely to be understood and well-received in the marketplace.  This can be advantageous.  Additionally, limited liability is a great benefit.  However, doing business in the corporate form requires that the participants truly recognize the entity as separate from themselves. This cannot be addressed with empty rhetoric.  It must be real.  If you do not respect the corporate form, the law will not respect your business as an entity, and you could be held personally liable for your business debts, liabilities, and obligations. Corporate formalities do not have to be a big deal; activities such as holding annual meetings, memorializing transactions, filing annual reports, etc., do not have to take a lot of time, but they must happen, and they do go a long way.

The major disadvantages of the corporate form are its required governing formalities, its separate income and double dividend taxation, and other tax issues, while certain corporate tax issues may be advantageous.

If your corporation will be a smaller to mid-sized entity whose primary payment structure will not be based on dividends, if you will seek broad-based financing through sales of equity shares, if you desire free share transferability or the convenience of share options for use as employee incentives, or if you will gain from certain corporate tax benefits, and if you have no problem realizing the distinction between yourself and the entity, [12]  this may be a business form to consider. It is essential to consider all relevant factors when contemplating Choice of Entity.


Close Corporation

WHAT IT IS

A close corporation is a business that is incorporated under a state business corporation statute specifically designed to allow a special variety of corporation with a limited number of owners.
A close corporation is distinguishable from a “closely-held” corporation.  A “closely-held” corporation, or “closely-held” business, is any non-public business or corporation with relatively few owners, including a close corporation.  But, all closely-held businesses are not necessarily formed under close corporation statutes.  Closely-held is a common-law term, not a statutory term.  Close corporations are defined by state statute.

Close corporation statutes generally permit shareholders to manage the business in place of directors.  In such case, shareholders are liable for management decisions and have fiduciary duties.  The shareholders may generally execute unanimous shareholder agreements (like bylaws) regarding corporate governance issues, and dispense with certain formalities (such as required shareholder meetings to elect directors).

Some statutes may limit the number of shareholders permitted in close corporations.

TAXES

A close corporation may generally be treated as a C-corporation, or elect to be treated as an S-corporation.

NOTEWORTHY

The close corporation has a history as a vehicle for family businesses or owner-investors who would have entered into limited partnerships, but prefer the close corporation’s liability protection and shareholder management feature (limited partners may not participate in management).  LLCs are now considered and typically favored by owner-investors.


Professional Corporation

WHAT IT IS

A professional corporation is a business owned, managed, and conducted by individuals who are licensed to engage in professional services, such as accountants, attorneys, nurses, dentists, doctors, etc.  All shareholders, directors, officers, agents, and employees must generally be licensed in a single professional field or related professional fields, depending on the field and state law.

Professional corporations are governed by state business statutes, and the practices are governed by the rules of the regulating authorities that license the respective professions.

Public policy prevents such professionals from avoiding personal liability for their services.  Thus, while individual practitioners are always liable for their own actions, the professional corporation (sometimes called a professional service corporation or personal service corporation) shields the practitioners from each others’ liabilities.

TAXES

The IRS generally classifies professional corporations as personal service corporations, and requires a calendar tax year.  Professional corporations may generally be treated as C-corporations, or elect to be treated as S-corporations.

NOTEWORTHY

The LLC is now more popular than the professional corporation, but professional corporations may be preferable for certain tax or other reasons, depending on the circumstances. Click to learn about our Choice of Entity Consult.

[1] (And a few notes on Close and Professional Corporations.)

[2] I.R.C. § 1361(a)(2) (1986).

[3] The business judgment rule is a common law principle.

[4] See I.R.C. §§ 3121 (d)(1), 3306 (i), and 3401 (c) (1986).

[5] I.R.S. Pub. 15-A, Employer’s Supplemental Tax Guide 5 (2013), available at http://www.irs.gov/pub/irs-pdf/p15a.pdf.

[6] See Rev. Rul. 58-505, 1958-2 C.B. 728.

[7 I.R.S. Pub. 542, Corporations 8-9 (2012), available at http://www.irs.gov/pub/irs-pdf/p542.pdf.

[8] http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Corporations.

[9] See I.R.S. Pub. 535, Business Expenses 6-8 (2012), available at http://www.irs.gov/pub/irs-pdf/p535.pdf.

[10] Id. at 6.  For a discussion of how to determine compensation reasonableness, see, e.g., Haffner’s Service Stations, Inc. v Commissioner, 326 F. 3d 1, 8-12 (1st Cir. 2003) (describing the tax issue and corresponding reasonableness tests throughout the circuits).

Under current law, both dividends and wages are treated as ordinary income to the recipient and taxed at the same rate. But for the corporation that makes the payments, wages are deductible while dividends are not. In close corporations, there is an obvious incentive to disguise dividend distributions as compensation expenses. See 26 C.F.R. § 1.162-7(b)(3) (2002). The opportunity exists because leading shareholders are also often managers of the company, and the benefit is obvious: by reducing corporate taxes, more accrues to the shareholders. See generally, e.g., 7 Mertens Law of Federal Income Taxation §§ 25E:04, 25E:29 (1996) (“Mertens”).

The Internal Revenue Code limits deductibility to “reasonable” compensation, 26 U.S.C. § 162(a)(1), which serves in part as a safeguard against conversion of dividends into salary. Treasury regulations — which are binding on us unless inconsistent with the statute, see Boeing Co. v. United States, ___ U.S. ___, 123 S.Ct. 1099, 1106-07, 155 L.Ed.2d 17 (2003) — require reasonableness to be based on “all circumstances.” 26 C.F.R. § 1.162-7(b)(1) (2002). What subsidiary factors are considered in this test of reasonableness is apparently a question of first impression in this circuit.

Other circuits and the Tax Court have employed multi-factor tests, the factors ranging from a handful to almost two dozen in various formulations. See Bittker & Lokken, Federal Taxation of Income, Estate and Gifts ¶ 22.2.2 (3d ed.1999) (collecting cases and discussing factors); 7 Mertens, § 25E:11-29 (same). By and large, longer lists include elements that, in shorter ones, are grouped together. The Second Circuit offers a typical example of a short collection: the employee’s role, payments by comparable companies, nature and condition of the company (e.g., earnings), incentives to distort, and consistency of compensation within the company.Dexsil Corp. v. Comm’r, 147 F.3d 96, 100 (2d Cir.1998).

The Seventh Circuit, in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), has vividly criticized the existing multi-factor tests as unpredictable. Id.at 835. The company reads the decision as laying down a single-factor test which asks whether “an independent investor” would approve the disputed compensation as a reasonable reward for the manager’s performance. It asks us to adopt the test for this circuit. But in Exacto Judge Posner conceded that the independent investor test was not an exclusive answer to the problem, id. at 839, and Exacto’s emphasis on the company’s profits reflected in part the character of that case.

There is always a balance to be struck between simplifying doctrine and accuracy of result, and for the present we think that multiple factors often may be relevant. Exacto remains a useful reminder that reasonableness under section 162(a)(1) is not a moral concern or a matter of fairness; the inquiry aims at what an arm’s-length owner would pay an employee for his work. The problem is that the actual payment — ordinarily a good expression of market value in a competitive economy — does not decisively answer this question where the employee controls the company and can benefit by re-labeling as compensation what would otherwise accrue to him as dividends.

Id.

[11] See I.R.S. Pub. 542, Corporations 9-21 (2012), available at http://www.irs.gov/pub/irs-pdf/p542.pdf.

[12] It is best if you are organized and responsible in your handling of corporate formalities, or have someone organized working with or for you.  Doing things such as meticulously recording all transactions, making your intentions explicit (an attorney can be a great help with this), and separating all things business from all things personal can help to make real your recognition of the corporate form.

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