Closed Entities And Pass Through Entities
So, which is better? Since the real issue is how the income of the entity is going to be taxed, the IRS has established the bar for this question. It is called “unreasonable compensation.” Essentially, the IRS has established a principle for all shareholders. Regardless of whether the shareholders are employees or not, they are entitled to earn a fair rate of return on their invested capital. If the executive/shareholder extracts too much compensation from the entity, they are cheating other shareholders of a fair rate of return. Therefore, the IRS places a restriction on how much compensation can be taken – an amount that is deemed to be reasonable. Any amount above that level of compensation will not be deductible as compensation and if distributed, will be considered a dividend and double taxed.
This restriction primarily affects a C corporation. . . .
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