Discussion:$1 year is a "reasonable" salary?

I don't understand how this is possible under the "reasonable salary" expectation for c- and s-corps. From everything I've been able to find, if I were to pay myself 1$ per year, and then compensate my self via dividends/stock grants etc from my company, I'd get audited and be on the hook for some huge tax liabilities. Is there something I'm missing here? Does being a public company exempt them from these rules or are there some other provisions that I'm unaware of/etc?

By the way, if you want a bracing read: http://articles.moneycentral.msn.com/Investing/SuperModels/warning-worldwide-wipeout-ahead.aspx The writer of this article has been right about a lot of things, but I sure hope he's wrong about this.

I concur, good point Rick.

Low salaries happens in LLC's and C Corporations, and excess compensation could happen in Sole Proprietorships. Under payment for a family member could also be an issue in various entities.

LH2004- Revenue Ruling 59-221 effectively states that any subchapter-s corporation must pay a "reasonable salary" to employees.

I suppose that, since a c-coporation is taxed at the corporate rate, while an s-corp is not, SOME of the savings from Steve's 1$ salary is still taxed anyway, first as corporate income and then as it is dividended out to him.

The reason I ask is because Steve is seemingly skirting paying employment taxes such as Medicare and FICA (only paying them on 1 dollar). So, "Steve" in this case doesn't pay any income tax, doesn't contribute to social security, and has an effective tax rate FAR below what most people are paying, because he is only getting taxed at the 15% rate for dividends.

If only *I* could get that kind of tax rate!

If there's disguised salary, there is employment tax. Unreasonably low salary does not imply that there is disguised salary.

The form states "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

In effect, this means that paying yourself $1 in salary, and $99,999 in dividends off of 100,000 net income would be setting yourself up for a serious audit.

I'm guessing that c-corps don't have any such directive.

I don't think they can be handed something of value without a tax event, can they?

Non-qualified stock options are wages, subject to withholding.

ISO's are not subject to reg tax but certainly are to AMT.

Vesting of restricted shares are wages sub to withholding.

I don't think they are merely receiving shares of no value, are they? Unless some sort of stock dividend?

Non-qualified stock options are not subject to withholding- they are only taxed when exercised.

"Incentive Stock Options" are even better- they are taxed as long term capital gains if held for 1 year before exercised (or meeting other, similar criteria).

Interestingly enough, here's what the IRS says about the value of employee stock options: 'Because most employee stock options are non-transferrable, are not immediately exercisable, and have other restrictions, the IRS considers that their "fair market value" cannot be "readily determined", and therefore "no taxable event" occurs when an employee receives an option grant.'

So, it seems that you COULD grant someone options and no tax event occurs. If the options are Qualified, Incentive Stock Options and they are held for the appropriate amount of time (and you meet the other criteria) you can exercise the options and only be taxed as if they were long-term capital gains.

Of course, in order to have this type of stock, you have to be a c-corp- which is why s-corps appear to be unable to do the same.

So it seems, that Steve in our discussion here could be granted Incentive Stock options and pay no immediate tax on them. As long as he exercises them appropriately, he will only be taxed at the long-term capital gains rate (which is much lower than the wage rate).

However, there are a lot of caveats and conditions that would push options like this into the realm of the Alternative Minimum Tax, which (originally) was created to tax just such arrangements, and prevent trusts and extremely wealthy people from creating tax shelters.

So, in closing, it seems you can't completely avoid being taxed on options. But, (with the limited understanding I have about all of this) it appears that this is a great strategy to chop your effective tax rate from 30% or so down to about half (the long term capital gains rate).

check out http://en.wikipedia.org/wiki/Employee_stock_option and http://en.wikipedia.org/wiki/Incentive_stock_option

Thanks for the discussion everyone, I've learned a TON!

Sorry, but your research has fallen just a wee bit short.

Stock options, be they nonqualified or qualified (aka incentive stock options), ARE NOT STOCK. They are granted to the holder when the strike or exercise price of the option is equal to the FMV of the stock at time of grant which equals nothing of value. Thus, no taxable event. As you state, there is likely a vesting schedule where the options BECOME EXERCISABLE over a period of time. Therefore, there is still no tax event at vesting of an option. They only give the holder an option to acquire the stock at the exercise price. No matter how long you hold the options, the holding period of the stock begins when the options are exercised. Let's say the holder exercises a vested option to purchase 1 share of stock at a cost of $10 when the FMV = $50. FMV = $50 Strike = $10 at exercise results in $40 of income subject to withholding. Basis = $50 and holding period begins at exercise. He can sell that share right away (and many do cashless exercises where they simultaneously exercise and sell). In this case, you would expect an additional Schedule D loss for the amount of the transactions cost.

So, upon exercise, the bargain element (diff in FMV and strike price) is W-2 income (NQUAL) subject to withholding and the basis in the shares is the FMV at exercise.

In the case of an ISO, the bargain element is not subject to withholding but is an AMT preference item and will most likely result in an AMT liability. These shares are not taxed for regular tax purposes until the shares are sold and will be subject to capital gain rates based on holding period. But again, THERE ARE NO SHARES UNTIL THE OPTIONS ARE EXERCISED.

If the stock price goes south of the exercise price after grant or at anytime prior to exercise, the options are considered "under water" and will expire worthless provided the stock price doesn't rebound enough to exceed the stock price prior to expiration.