Many businesses host a picnic for employees in the summer. It’s a fun activity for your staff and you may be able to take a larger deduction for the cost than you would on other meal and entertainment expenses.

Deduction limits

Generally, businesses are limited to deducting 50% of allowable meal and entertainment expenses. But certain expenses are 100% deductible, including expenses:

There is one caveat for a 100% deduction: The entire staff must be invited. Otherwise, expenses are deductible under the regular business entertainment rules.

Recordkeeping requirements

Whether you deduct 50% or 100% of allowable expenses, there are a number of requirements, including certain records you must keep to prove your expenses. If your company has substantial meal and entertainment expenses, you can reduce your tax bill by separately accounting for and documenting expenses that are 100% deductible. If doing so would create an administrative burden, you may be able to use statistical sampling methods to estimate the portion of meal and entertainment expenses that are fully deductible.

For more information about deducting business meals and entertainment, including how to take advantage of the 100% deduction, please contact us.

What you need to know to combat tax identity theft

 
Earlier this year, the U.S. Federal Trade Commission (FTC) reported there was an almost 50% jump in identity theft complaints in 2015. The primary driver of that spike, by far, was tax identity theft. The FTC received 490,220 complaints about identity theft last year, with tax identity theft accounting for 221,854 of the complaints. 
 
It’s obvious that individuals can’t afford to ignore the threat of tax identity theft, but the IRS has taken some measures to combat the epidemic that has implications for employers, too. Businesses also need to be aware of the risk of tax identity theft they face. Criminals aren’t just pursuing Social Security numbers (SSNs) — they’re also going after employer ID numbers (EINs) assigned by the IRS.  

Individual tax identity theft

To date, most of the attention has been paid to individual victims of tax identity theft. According to the IRS, it occurs when someone uses a stolen SSN to file a tax return claiming a fraudulent refund. The victim may be unaware of this until he or she attempts to file a return and learns that one has already been filed. Alternatively, the IRS might send a taxpayer a letter saying it has identified a suspicious return with the taxpayer’s SSN. The U.S. Government Accountability Office found that the IRS paid out $5.8 billion dollars in fraudulent refunds for the 2013 tax year.
 
In addition, a fraudster might use another’s SSN to obtain a job. The employer then reports that person’s income to the IRS under the stolen SSN. The victim, obviously, won’t include those earnings when filing his or her tax return, so IRS records will indicate that the victim underreported income.
 
How does a fraudster obtain an SSN? These thefts can often be traced back to the victim’s place of employment. Insiders at a company may steal the numbers and other employee or customer information. Perpetrators also might wait until staff members let their guards down and leave SSNs readily accessible on computers or in waste receptacles. And, of course, individuals may simply be careless with their SSNs and other sensitive information.
While large companies like banks and hospitals are favorite targets, the improper lifting of just a single SSN can wreak havoc for one of your employees or customers. That means smaller companies are at risk, too.

IRS actions 

Tax identity theft is a top concern for the IRS, which has again placed it on its annual “Dirty Dozen Tax Scams” list. The agency will be implementing new provisions and is working with states and the payroll industry to put new safeguards in practice.
 
Most notably for employers, the Protecting Americans from Tax Hikes (PATH) Act signed in late 2015 now requires employers to file W-2, W-3 and 1099 forms by January 31 of the year following the tax year. The idea is that it will be easier for the IRS to catch discrepancies between legitimate forms filed by employers and those filed by fraudsters seeking refunds based on false forms — before the agency sends out refund checks.
 
The earlier deadline takes effect for statements filed in 2017 for the 2016 tax year. (W-2s and 1099s still must be furnished to employees and payees by January 31.) With these forms now due to be filed with the IRS a month earlier than in the past (or, for electronic filers, two months earlier), employers will need to pull together the necessary information more promptly. 
 
The IRS is also expected to expand a pilot program it launched this year to verify the authenticity of W-2 data submitted by taxpayers on electronically filed tax returns. For the pilot program, the IRS partnered with several major payroll service providers to provide a 16-digit code and a new Verification Code field on a limited number of W-2 copies provided to employees. Each unique number is derived from data on the form itself and therefore is known only to the IRS, the payroll service provider and the employee. The IRS plans to broaden the scope of the program for the 2017 filing season by increasing the number and types of W-2 issuers involved.

Risks for businesses

Thieves are going after EINs, which is a startling proposition for the many businesses that put far more effort into protecting SSNs than their EINs. A fraudster could use a stolen EIN to report false income and withholding and file for a refund. The Treasury Inspector General for Tax Administration has estimated that the IRS could issue almost $2.3 billion in potentially fraudulent tax refunds based on EINs annually. Moreover, the legitimate business could find the IRS coming after it for payroll taxes that were reported as withheld but not remitted.
 
As with SSN theft, EIN theft victims may not discover something’s amiss until they file their tax returns and receive IRS notification that they had already filed for that tax year. They also might be tipped off by receipt of an IRS notice regarding nonexistent employees.

Tips for preventing tax identity theft

You can take several steps to help reduce the risk of theft of SSNs and EINs, including:
Businesses should bear in mind — and remind their employees and customers — that the IRS doesn’t initiate contact with taxpayers by email, text messages or social media to request personal or financial information.

Don’t put your head in the sand

The risk of tax identity theft, whether of SSNs or EINs, is real. We can help you take the necessary steps to avoid the morass of negative consequences that can result for a business and its employees and customers.
 
Side Note:
 
Some tax refunds delayed next year to help combat tax identity theft
In efforts to combat target areas of identity theft, no credit or refund will be issued before February 15 on returns processed in early 2017 with the Earned Income Credit and/or the Additional Child Tax Credit, due to a mandate enacted December 18, 2015 by the PATH Act. Since many of the fraudulent returns contain refundable credits, the delay in processing refunds will allow the IRS more time to analyze returns for validity.

 

If your business claims deductions for meal, entertainment, vehicle or travel expenses, be aware that the IRS may closely review them. Too often, taxpayers don’t have the necessary documentation to meet the strict requirements set forth under tax law and by the IRS.

Be able to withstand a challenge

Whether you file a business return or file Schedule C with your personal return, these deductions can be a hot button for the IRS. Here are some DOs and DON’Ts:

DO keep detailed, accurate records. Documentation is critical when it comes to deducting meal, entertainment, vehicle and travel expenses. You generally must have receipts, canceled checks or bills that show amounts and dates. In addition, there are other rules for specific expenses. For example, you must record the business purpose of entertainment expenses, as well as the names of those you entertained and their business relationship to you. If you reimburse employees for expenses, make sure they comply with the rules.

DON’T re-create expense logs at year end or wait until you receive an IRS deficiency notice. Take a moment to record the details in a log or diary at the time of the event or soon after. Require employees to submit monthly expense reports.

DO keep in mind that there’s no “right” way to keep records. The IRS website states: “You may choose any recordkeeping system suited to your business that clearly shows your income and expenses.”

DO respect the fine line between personal and business expenses. Be careful about trying to combine business and pleasure. For example, you can’t deduct expenses for a spouse on a business trip unless he or she is employed by the company and there’s a bona fide business reason for his or her presence.

We can help

These are general rules and there may be exceptions. If your records are lost due to, say, a fire, theft or flood, there may be a way to estimate expenses. With guidance from us, you can maintain records that can stand up to IRS scrutiny. For more information about recordkeeping, contact us.

Individuals

Charitable Deductions

Summertime means cleaning out those often neglected spaces such as the garage, basement, and attic for many of us. Whether clothing, furniture, bikes, or gardening tools, you can write off the cost of items in good condition donated to a qualified charity. The deduction is based on the property's fair market value. Guides to help you determine this amount are available from many nonprofit charitable organizations.

Charitable Travel

Do you plan to travel while doing charity work this summer? Some travel expenses may help lower your taxes if you itemize deductions when you file next year:
  1. You must volunteer to work for a qualified organization. Ask the charity about its tax-exempt status. 
  2. You may be able to deduct unreimbursed travel expenses you pay while serving as a volunteer. You can’t deduct the value of your time or services.
  3. The deduction qualifies only if there is no significant element of personal pleasure, recreation or vacation in the travel. However, the deduction will qualify even if you enjoy the trip.
  4. You can deduct your travel expenses if your work is real and substantial throughout the trip. You can’t deduct expenses if you only have nominal duties or do not have any duties for significant parts of the trip.
  5. Deductible travel expenses may include:

    • Air, rail and bus transportation
    • Car expenses
    • Lodging costs
    • The cost of meals
    • Taxi fares or other transportation costs between the airport or station and your hotel

Renting Your Vacation Home

A vacation home can be a house, apartment, condominium, mobile home or boat. If you rent out a vacation home, you can generally use expenses to offset taxable income from the rental. However, you can't claim a loss from the activity if your personal use of the home exceeds the greater of fourteen days or 10% of the time the home is rented out. Watch out for this limit if taking an end-of summer vacation at your vacation home. 
 

Businesses

Traveling for Business

When you travel away from home, you may deduct your travel expenses – including airfare, train, bus, taxi, meals (generally limited to 50%), lodging – as long as the primary purpose of the trip is business-related. You might have some downtime relaxing, but spending more time on business activities is critical. Note that the cost of personal pursuits is not deductible.

Entertaining Clients

If you treat a client to a round of golf at the local club or course, you may deduct qualified expenses – such as green fees, club rentals, and 50% of your meals and drinks at the nineteenth hole – as long as you hold a "substantial business meeting" with the client before or after the golf outing. The discussion could take place a day before or after the entertainment if the client is from out of state. For information on what does and does not qualify, please contact us.

Using Your Home Office  

Home office expenses are generally deductible if part of a business owner's personal residence is used regularly and exclusively as either the principal place of business or as a place to meet with patients, customers or clients. The IRS provides an optional safe-harbor method that makes it easier to determine the amount of deductible home office expenses. These rules allow you to deduct $5 per square foot of home office space (up to 300 square feet). In addition, deductions such as interest and property taxes allocable to the home office are still permitted as an itemized deduction for taxpayers using the safe harbor.
The U.S. Department of Labor (DOL) has released a final rule that makes significant changes to the determination of which executive, administrative and professional employees — otherwise known as “white-collar workers” — are entitled to overtime pay under the Fair Labor Standards Act (FLSA). The rule will make it more difficult for employers to classify employees as exempt from overtime requirements. In fact, the DOL estimates that 4.1 million salaried workers will become eligible for overtime when they work more than 40 hours in a week.
 
The changes will have a tax impact as well: Employers’ payroll tax liability will increase as they pay overtime to more employees who work in excess of 40 hours a week or pay higher salaries to maintain overtime exemptions. 

Current requirements for white-collar exemptions

To qualify for a white-collar exemption from the overtime requirements under current federal law, an employee generally must satisfy three tests:
  1. Salary basis test. The employee is salaried, meaning he or she is paid a predetermined and fixed salary that’s not subject to reduction because of variations in the quality or quantity of work performed.
  2. Salary level test. The employee is paid at least $455 per week or $23,660 annually.
  3. Duties test. The employee primarily performs executive, administrative or professional duties.
Neither job title nor salary alone can justify an exemption — the employee’s specific job duties and earnings must also meet applicable requirements.
 
Certain employees (for example, generally doctors, teachers and lawyers) aren’t subject to either the salary basis or salary level tests. The current regulations also provide a relaxed duties test for certain highly compensated employees (HCEs) who are paid total annual compensation of at least $100,000 and at least $455 per week.

Significant changes under the final rule

The DOL issued a proposed rule in July 2015, revising the 2004 regulations, and received more than 270,000 comments in response.
 
The revisions in the final rule, which take effect December 1, 2016, mainly relate to the salary level test. The rule increases the salary threshold for exempt employees to the 40th percentile of weekly earnings for full-time salaried workers in the lowest-wage Census region (currently the South) — $913 per week or $47,476 per year. 
 
In response to what the DOL described as “robust comments” from the business community, the final rule allows up to 10% of the salary threshold for non-HCE employees to be met by nondiscretionary bonuses, incentive pay and commissions, as long as these payments are made on at least a quarterly basis. Thus, an employee’s production or performance bonuses could push him or her over the threshold and into exempt status (assuming the other tests are satisfied).
 
The rule also updates the HCE threshold above which the relaxed duties test applies. It raises the level to the 90th percentile of full-time salaried workers nationally, or $134,004 per year. 
 
The final rule continues the requirement that HCEs receive at least the full standard salary amount — or $913 — per week on a salary or fee basis without regard to the payment of nondiscretionary bonuses and incentive payments. Such payments will, however, count toward the total annual compensation requirement.
 
The standard salary and HCE annual compensation levels will automatically update every three years to maintain the levels at the prescribed percentiles, beginning January 1, 2020. The DOL will post new salary levels 150 days before their effective date.

The duties test

The final rule makes no changes to the duties test. In the proposed rule, the DOL had sought comments regarding the effectiveness of the test at screening out workers who aren’t bona fide white-collar workers. 
 
But it determined that the new standard salary level and automatic updating will work with the duties test to distinguish between overtime-eligible workers and those who may be exempt. Moreover, as a result of the revised salary level, employers won’t need to consider the duties test as often — if a worker’s pay doesn’t satisfy the salary level test for exemption, the employer needn’t bother assessing the worker’s duties.

Compliance options

According to the DOL, employers have a range of options when it comes to complying with the changes to the salary level (although it doesn’t require or recommend any method). Options include:
 
Review and do nothing. After completing an internal review, you might choose to do nothing if your white-collar workers fall short of the new salary level but don’t ever work more than 40 hours per workweek.
 
Raising salaries. You may want to raise the salaries of employees who meet the duties test, have salary near the new salary level and regularly work overtime. Paying them at or above the salary threshold will maintain their exempt status.
 
Paying overtime above a salary. You could continue to pay employees a salary covering a fixed number of hours, which could include hours above 40. For example, you might:
And, of course, you might reorganize workload distributions or adjust employee schedules to redistribute work hours in excess of 40 across current staff. You could also hire additional employees to reduce or eliminate overtime hours worked by your current staff.

The big picture

As noted, the cost of the new overtime rules is more than just the increased compensation; it also includes additional payroll tax liability on that compensation, as well as administrative costs to comply. This is a complex and complicated issue; and we recommend you consult your employment advisor with questions or concerns.

What every landlord should know about reporting of rental income and expenses

Accounting for rental income might at first seem like a simple concept, but in practice it may not be so simple. What is the difference between “rental income” and “advance rent”? How does one account for a security deposit, or property or services received in lieu of rent? How is personal use of a vacation home or other rental property treated? This article addresses those questions.

Rental income is any payment received or accrued for occupancy of real estate or the use of personal property. Rental income is generally included in gross income when actually or constructively received. Cash basis taxpayers report income in the year received, regardless of when it was earned. 

Advance rent is any amount received before the period that it covers. Landlords are required to include advance rent in rental income in the year received, regardless of the period covered or the accounting method used by the taxpayer. An amount received by a landlord from a tenant for cancelling a lease constitutes income in the year in which it is received since it is essentially a substitute for rental payments.

Do not include a security deposit in income when received if it is to be returned to the tenant at the end of the lease. If part or all of the security deposit is retained during any year because the tenant does not live up to the terms of the lease, include the amount retained in income for that year. If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in income when received.

Expenses of renting property can be deducted from gross rental income. Rental expenses are generally deducted by cash basis taxpayers in the year paid.  

If the tenant pays any expenses that are the landlord’s obligations, the payments are rental income for the landlord and must be included in income. These expenses may be deducted if they are otherwise deductible rental expenses. Property or services received in lieu of rent are reportable income as well. Landlords should include the fair market value of the property or services provided by the tenant in rental income. Services at an agreed upon or specified price are assumed to be at fair market value unless there is evidence to the contrary. There are specific rules related to leasehold improvements so please contact your tax advisor prior to entering into these transactions.

Personal use of a vacation home or other rental property requires that the expenses be allocated between the personal and rental use. If the rental expenses exceed rental income, the rental expenses will be limited.

If you have questions about how to treat expenses and income related to your rental property, our tax advisors would be happy to assist you. 

Colorado offers a conservation easement tax credit program that could save you money while at the same time help preserve Colorado’s natural treasures. Landowners who permanently preserve part of their land for agriculture, scenic views or wildlife habitat can generate Colorado income tax credits that can then be sold to taxpayers.

Purchasing these tax credits could be an excellent strategy if you have a Colorado income tax liability of at least $10,000. The tax credit is not a tax deduction, but rather is a dollar-for-dollar reduction of state tax liability. 

Background on conservation easements in Colorado 

Landowners who desire to conserve the special qualities of their land — for example, its productive farm soils, scenic beauty or valuable wildlife habitat – can choose to place a conservation easement on all or a portion of it. Conservation easements give people the assurance that the places they love will be protected forever.  A conservation easement is a legal agreement that runs with the land, in perpetuity. Conservation easements may or may not allow public access to the protected property.  Over two percent of the land in Colorado is protected by conservation easements, including land in every county.

Colorado requires a conservation easement holder (typically a land trust) to have the responsibility of stewardship for the land. Landowners retain full ownership of the land. Once the easement is in place, the landowner receives Colorado conservation easement tax credits which can be used against their Colorado tax liability or sold to a third party.

Who can purchase conservation easement tax credits?

Individuals and entities with Colorado state income tax liability may purchase tax credits. There is no limit to the amount of tax credits that any individual or entity may purchase. 

The cost and benefit of purchasing a conservation easement tax credit

The major benefit of purchasing conservation easement tax credits is that they can be purchased at a discount, often at a savings of 10-14%. For example, if you have a $100,000 state income tax liability, you can purchase $100,000 worth of tax credits for between $86,000-90,000, thereby saving $10,000-14,000. 

Here is an example to illustrate how purchasing conservation easement tax credits could benefit you:

  1. The Sellers place a conservation easement on part of their land which generates Colorado conservation easement tax credits.
  2. They want to sell their tax credits, so they work with a broker to find a buyer.
  3. The Buyers have a Colorado tax liability of $100,000. They want to offset their tax liability by purchasing tax credits so they contact a conservation easement tax credit broker.
  4. The Buyers purchase $100,000 worth of credits through the broker for the discounted rate of 87%, or $87,000.
  5. The Buyers can use the $100,000 of purchased credits against their $100,000 Colorado tax liability, reducing their liability to $0.
  6. Thus, instead of paying $100,000 in taxes, they paid $87,000 in conservation easement tax credits which both saved them $13,000 and also helped preserve some of Colorado’s land – a win-win!

The process

First, it’s good idea to have an idea of what your Colorado tax liability will be for the upcoming year. Your tax advisor can assist you in this. 

Secondly, although not a requirement, it is advisable to purchase tax credits through a reputable broker. Brokers know this process intimately and can efficiently guide a buyer through each step. There are some risks involved when purchasing conservation easement tax credits; these can be greatly minimized by using a reputable broker.

A tax credit broker will match you up with a conservation easement seller and will verify the validity of the credits. The broker also prepares the documents to transfer the credits from the seller to the buyer.

Next steps

In addition to conservation tax credits, Colorado also offers environmental remediation (Brownfield) tax credits and historic preservation tax credits. If you think you have a Colorado tax liability of at least $10,000 and would like more information on tax credits, please contact our office to discuss the details of your specific situation. Tax credits are in high demand and as a result some brokers have waiting lists already forming, so do not hesitate for long.

 

The research and development tax credit has been a great tax savings incentive to companies looking to increase their internal research and development activities. When President Obama signed the Protecting Americans from Tax Hikes (PATH) Act on December 18, 2015, the research and development (R&D) credit was finally made permanent (retroactively as of January 1, 2015). In addition, the credit now contains two new options for utilization that did not previously exist which broadens the impact of the credit for many small to mid-sized businesses.

Two New Provisions

Previously, the R&D tax credit could only be used to offset regular tax; this rule limited many small to mid-sized businesses in their ability to use the credit if they were subject to the alternative minimum tax (AMT). Beginning in 2016, businesses with less than $50 million in gross receipts will be free to use the credit to offset AMT.

In addition, certain start-up businesses (with less than $5 million in gross receipts) that may not have an income tax liability will be able to offset payroll taxes with the credit to the tune of $250,000. No longer will they have to wait until they generate taxable income to take advantage of the credit savings.

Four Part Test

Businesses should be aware of the four part test that research activities must pass before the corresponding expenditures related to those activities will qualify for the tax credit. The four part test is as follows:

  1. The R&D activity must be intended to be useful in the development of a new or improved business component for the taxpayer, such as a product, process, technique, formula, invention or software.
  2. The project must be undertaken for the purpose of discovering information that is technological in nature. Thus, the activity must rely on the principles of physical sciences, such as engineering, biology or computer science.
  3. The project must be intended to eliminate uncertainty related to the development or improvement of a business component. Uncertainty can include the capability, development method or optimal design of the business component.
  4. The project must evaluate one or more alternative solutions through the development, refinement and testing of different options. Furthermore, technical risk must be present, which means that there is a chance the project will not be successful.

If you are planning on claiming an R&D tax credit on your business’ next tax return, please consult your tax advisor.  Although the benefits of the R&D credit make it attractive, now more than ever, you will want to make certain that you meet the requirements because it has become one of the most heavily audited tax credits by the IRS in recent years. 

Generally, one of the requirements for maintaining a corporation’s existence (and the liability protection that it affords) is that the shareholders and Board of Directors must meet at least annually. Although most people view this requirement as a necessary evil, it doesn’t have to be a waste of time. For example, in addition to being a first step in making sure the corporation is respected as a separate legal entity, an annual meeting can be used as an important tool to support your company’s tax positions.

 

Besides the election of officers and directors, other actions that should be considered at the annual meeting include the directors approving the accrual of any bonuses and retirement plan contributions, and ratifying key actions taken by corporate officers during the year. It is common for the IRS to attack the compensation level of closely held C corporation shareholder/officers as unreasonably high and, thereby, avoiding taxation at the corporate level. A well-drafted set of minutes outlining the officers’ responsibilities, skills, and experience levels can significantly reduce the risk of an IRS challenge. If the shareholder/employees are underpaid in the start-up years because of a lack of funds, it is also important to document this situation in the minutes for future reference when higher payments are made.

 

The directors should also specifically approve all loans to shareholders. Any time a corporation loans funds to a shareholder, there is a risk that the IRS will attempt to characterize all or part of the distribution as a taxable dividend. The primary documentation that a distribution is intended to be a loan rather than a dividend should be in the written loan documents, and both parties should follow through in observing the terms of the loan. However, it is also helpful if the corporate minutes document the need for the borrowing (how the funds will be used), the corporate officers’ authorization of the loan, and a summary of the loan terms (interest rate, repayment schedule, loan rollover provisions, etc.).

 

A frequently contested issue regarding a shareholder/employee’s use of employer-provided automobiles is the treatment of that use as compensation (which is deductible by the corporation) vs. treatment as constructive dividends (which is not deductible by the corporation). Clearly documenting in the corporate minutes that the personal use of the company-owned automobile is intended to be part of the owner’s compensation may go a long way in ensuring the corporation will get to keep the deduction.

 

If the corporation is accumulating a significant amount of earnings, the minutes of the meeting should generally spell out the reasons for the accumulation to help prevent an IRS attempt to assess the accumulated earnings tax. Also, transactions intended to be taxable sales between the corporation and its shareholders are sometimes recharacterized by the IRS and the courts as tax-free contributions to capital. Corporate minutes detailing the transaction are helpful in supporting a bona fide sale.

 

As you can see, many of the issues raised by the IRS involve the payment of dividends by the corporation. (The IRS likes them — the corporation doesn’t.) To help support the corporation’s stance that payments to shareholders are deductible and that earnings held in the corporation are reasonable, corporate minutes should document that dividend payments were considered and how the amount paid, if any, was determined. Dividends (even if minimal) should generally be paid each year, unless there’s a specific reason not to pay them — in which case, these reasons should be clearly documented.

 

These are just a few examples of why well-documented annual meetings can be an important part of a corporation’s tax records. As the time for your annual meeting draws near, please call us if you have questions or concerns.

 

Determining how much a business should pay its owners is never easy. You’ve got to consider a variety of factors, including just what form (salaries, benefits, stock) that compensation will take. You also need to ensure your approach will hold up under IRS scrutiny.
 

Balancing act

 
Let’s start with the basics. Compensation is affected by the amount of cash in your company’s bank account. But just because your financial statements report a profit doesn’t necessarily mean you’ll have cash available to pay owners a salary or make annual distributions. Net income and cash on hand aren’t synonymous.
 
Other business objectives — for example, buying new equipment, repaying debt and sprucing up your office — will demand dollars as well. So, it’s a balancing act between owners’ compensation and dividends on the one hand, and capital expenditures, expansion plans and financing goals on the other.
 

Dividend double-taxation

 
If you operate as a C corporation, your business is taxed twice. First, business income is taxed at the corporate level. Then it’s taxed again at the personal level as you draw dividends — an obvious disadvantage to those owning C corporations.
 
C corporation owners might be tempted to classify all the money they take out as salaries or bonuses to avoid being double-taxed on dividends. But the IRS is wise to this strategy. It’s on the lookout for excessive compensation to owners and will reclassify above-market compensation as dividends, potentially resulting in additional income tax as well as interest and penalties.
 
The IRS also monitors a C corporation’s accumulated earnings. Generally similar to retained earnings on your balance sheet, accumulated earnings measure the buildup of undistributed earnings. If these earnings get too high and can’t be justified as needed for such things as a planned expansion, the IRS will assess a tax on them.
 

Other business structures

 
Perhaps your business is structured as an S corporation, limited liability company or partnership. These are all examples of flow-through entities that aren’t taxed at the entity level. Instead, income flows through to the owners’ personal tax returns, where it’s taxed at the individual level.
 
Dividends (typically called “distributions” for flow-through entities) are tax-free to the extent that an owner has tax basis in the business. Simply put, basis is a function of capital contributions, net income and owners’ distributions.
 
So, the IRS has the opposite concern with flow-through entities: Agents are watchful of dealer-owners who underpay themselves to avoid payroll taxes on owners’ compensation. If the IRS thinks you’re downplaying compensation in favor of payroll-tax-free distributions, it’ll reclassify some of your distributions as salaries. In turn, while your income taxes won’t change, you’ll owe more in payroll taxes than planned — plus, potentially, interest and penalties.
 

Red flags, higher taxes

 
Above- or below-market compensation raises a red flag with the IRS — and that’s definitely undesirable. Not only will the agency evaluate your compensation expense — possibly imposing extra taxes, penalties and interest — but a zealous IRS agent might turn up other challenges in your records, such as nonsalary compensation or benefits.
 
What’s more, it might cause a domino effect, drawing attention in the states where you do business. Many state and local governments face budget shortages and are hot on the trail of the owners’ compensation issue and will follow federal audits to assess additional taxes when possible.
 

Other interested parties

 
Other parties also might have a vested interest in how much you’re getting paid. Lenders, franchisors and minority shareholders, for instance, could think you’re impairing future growth by paying yourself too much.
 
Plus, if you or your business is involved in a lawsuit, the courts might impute reasonable (or replacement) compensation expense. This is common in divorces and minority shareholder disputes. In these situations, you’d be wise to consult an attorney early in the compensation decision-making process.
 

Best practice

 
The best practice in owners’ compensation is to see to it that you’re being fairly compensated — and that you’re in line with industry figures. Avoid red flags, and your decisions should be able to withstand outside scrutiny.