It's your ISP business, you operate it and you own it. So why should the Internal Revenue Service care what you pay yourself?

by Mark E. Battersby [February 28, 2001]

The answer is that the IRS cares about how you pay yourself. It cares about what form your ISPs earnings take when profits are transferred to you, because how has quite a bit to do with the how much taxes will be paid.

The ISP operator who takes a salary from his or her business pays taxes on that salary. The tax rate is roughly comparable to that which the ISP business would have paid, had the salary not been tax deductible.

Pay the same salary amount to yourself in the form of dividends, however, and the tax bill increases substantially. Your tax bill increases as the result of a unique "double tax" on dividends.

Dividend double dip
An incorporated Internet business cannot deduct taxes on the amounts paid to you, your employess or your investors, as dividends.

The incorporated Internet business is already taxed on profit, which is then paid out in the form of a dividend to shareholders. A dividend is, of course, included in the recipient's taxable income when individual earnings are reported.

And so, the dividend is double taxed; once at the corporate level and again on a much more personal—your imcome taxes.

Passing a reasonable test
Under our current tax laws, any ISP business is entitled to deduct a reasonable allowance for salaries or other compensation paid for personal services. However, there is a notable exception for publicly-held corporations, which are generally not able todeduct compensation paid to certain employees in excess of $1 million a year. Even then, the restriction does not apply to certain performance-based compensation.

According to the IRS, the test for reasonable in the reasonable compensation equasion, is that it must be an amount that would reasonably be paid for services by like enterprises, in like circumstances. Additional factors often considered by the IRS include such things as the recipient's personal ability, the responsibility of the position held, and economic conditions in the locality where the services are performed.

Court decisions dealing with excessive salaries arise almost exclusively with closely-held companies. Each case is usually decided upon its particulars. However, the U.S. Court of Appeals for the Seventh Circuit, recently developed a so-called independent-investor test. This test presumes that compensation is reasonable if the company's investors earn their expected rate of return. Consider this the street rules of the reasonable test.

In other words, under this test, if a profitable ISP business can pay its owner and, or shareholders a salary or bonuses and still have earned sufficient profits to provide an investor—real or hypothetical—with a reasonable return on the investment then, in the eyes of the court, the compensation should be considered reasonable.

Repayment Loophole
Again under the guidance of current tax rules, officer-shareholders of a closely-held, incorporated ISP business may deduct repayments of salary to their corporations that are made pursuant to an agreement requiring such repayments—in the event that the IRS determines the salaries to be excessive.

Naturally, the officer-shareholder may claim the deduction only if the agreement is legally enforceable and was in existence before the payment of the amounts.

Accumulating taxes
Obviously, every ISP business could both problems concerning unreasonable compensation and the double-tax on dividends by simply leaving the money in the business. Unfortunately, our wiley lawmakers and the IRS have already compensated for just such a strategy in the form of the accumulated earnings tax.

The accumulated earnings tax is an extra tax—in the form of a penalty—that is imposed if an incorporated ISP business is formed or operated for the purpose of permitting earnings or profits to accumulate, instead of being distributed. You better sit down and prepare yourself for this next statement.

The rate of taxation on improper accumulated earnings is a whopping 39.6 percent. That's just less than 40 percent of your hard-hearned profits going to the U.S. Treasury Department. However, there is a credit your ISP business could take, should your business be penalized for squirrling away accumulated taxable income.

Reasonable credits
Allowable accumulated earnings credits are amounts equal to that portion of the earnings and profits retained by the business for the reasonable needs of that business. A minimum amount of $250,000 ($150,000 for personal service corporations), may be accumulated from both past and present accumulated earnings—combined.

If an ISP operation's accumulated earnings exceed the amount of this credit, in order to justify that accumulation of income, there must be a reasonable business need for it and a definite plan for its use.

Let's be reasonable
Obviously, an ISP owner and, or shareholder wants to get as much of the operation's earnings and profits out of the business as reasonably possible—at the lowest possible tax rates.

If the ISP business turns a profit, corporate taxes are paid. If dividends are paid, then a double-tax is incurred. If too much profit is left in the business, then your ISP operation could lose a big chunk of its profits and have to fight to keep that which is deemed reasonable.

What could the reasonable ISP operator do to protect the earnings of an incorporated, publicly-held business? What's a reasonable way to deal with all taxing issues?

Simple, cut yourself a paycheck every two weeks. Taking profits out of your ISP business in the form of just compensation and bonuses is the least expensive, legal answer to protecting your ISPs earnings.

One caveat exists; beware of receiving to high a salary. After all, tax brackets are traps for too much profit taking in the form of unreasonable compensation.

— End