A C corporation is a type of business organization that is a separate legal entity from its owners, or shareholders. This means that the shareholders are not personally responsible for the business’s liabilities, but the corporation must take steps to meet certain responsibilities. One of those responsibilities is paying its employees. The rules for paying salaried workers of a corporation may vary based on whether the employee is a shareholder of the corporation and whether the salary is considered "excessive."
Fair Labor Standards Act and Salaried Employees
The Fair Labor Standards Act (FLSA) is a federal law that dictates how employees are paid in relation to wages and overtime. All employers must comply with these rules in paying their employees unless the job in question is “exempt.” Among the exempt jobs are certain types of salaried positions. To qualify for the exemption, the job must require that an employee be paid a certain, guaranteed amount of money every week she performs any work. The work must be of a certain type, such as managing a part of the business; participating in a “learned profession" such as being a doctor; or performing nonmanual work that supports management by the employee exercising independent judgment on matters significant to the business. The job must also pay at least $23,600 per year. If the job qualifies, the corporation does not have to comply with the FLSA with regard to those employees.
Some shareholders of the company may also be employed by the corporation. This is common practice, especially as some corporations pay their employees by issuing them stock. In other types of business organizations, such as sole proprietorships, the owner has to pay “self-employment” tax on what he receives from the business. Since a corporation is an independent legal entity, the shareholder-employees do not have to pay self-employment tax. Instead, the employees must pay half the employment taxes while the corporation pays the other half.
Since a corporation pays taxes, an important consideration is what it can deduct from its gross income for tax purposes. A corporation can deduct the wages and salaries it pays its workers. However, the IRS will only permit the corporation to deduct “reasonable” wages"; if the corporation pays its employees, but especially its management, an unreasonably lavish salary, the IRS will not permit all of it to be deducted. There is no definitive test to determine what constitutes a reasonable salary, but generally the IRS and a reviewing court will consider what other people with similar jobs earn as well as the employee's performance.
Salary vs. Dividend Income
If the income is excessive, and the recipient of the salary is an employee-shareholder, the IRS can relabel the “excessive” portion of the salary as a dividend distribution. While the excessive portion of the salary can no longer be deducted, the recipient generally does not have to pay his standard income tax rate on that portion. Instead, he can pay the lower capital tax rate on that amount.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.