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Most entrepreneurs long for the day when their most pressing problem is figuring out what to do with
all the money their business is generating. Yet this very condition was now occupying Morris‟s mind.
Brad did not present any problems in this context. His compensation package would be dealt with
through ongoing negotiations and, of course, he was not family. But Morris was responsible for
supporting his wife and two children. Despite what Morris perceived as the unproductive nature of
Victor‟s pursuits, Morris was determined to maintain a standard of living for Victor befitting the son
of a captain of industry. Of course, Lisa was also entitled to an affluent lifestyle, but surely she was
additionally entitled to extra compensation for her long hours at work.
The simple and natural reaction to this set of circumstances would be to pay Lisa and Morris a
reasonable salary for their work, and have the corporation pay the remaining distributable profit (after
retaining whatever was necessary for operations) to Morris. Morris could then take care of his wife
and Victor as he saw fit. Yet such a natural reaction would ignore serious tax complications.
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 wellknown
bugaboo of corporate double taxation). A dollar of profit could easily be reduced to as little as
43 cents of after-tax money in Morris‟s pocket (see Exhibit 9.1).
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 a so-called employee who
expends no such efforts.
Exhibit 9.1 Double taxation.
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