Business people are often misled by their investments in their own companies. How much to invest in the company and how much to pay to themselves? These are constant questions of operating a business.

Business people who borrow money from their companies frequently face an I.R.S. challenge. To win the case they need to have a signed note with a repayment schedule and a stated interest rate. Otherwise, the tax people are likely to view the loan as a dividend, taxable to both the business and the owner. There are more and more cases where the I.R.S. has accused business owners of family-owned S corporations of underpaying themselves.  

So, how much to pay and how much is right? The amount depended on the business and on its industry. One of the creative things business people do to keep themselves from running afoul of the I.R.S. is to keep careful minutes of board meetings and record any bonuses paid, making clear that they are performance related, not paid because the owner wanted a new car or luxurious dwelling.

Another is to insure that compensation is based on service rendered, not on the percentage of stock held. The I.R.S. is likely to view payment for stock holdings as a dividend. The last one can’t be deducted as a business expense, but compensation can be, however. The third one is to convert to an S corporation, the entity which allows earnings flow through to the owners, rather than being retained at the corporate level. This type of corporation is not always preferable, because of the various restrictions on S corporations, where only one class of stock and the corporation is must have 35 or fewer shareholders, all United States residents.

In case you go on a regular C corporation, compensation should always reflect performance, not a current performance, however. Although it’s very easy for business people to identify themselves with the company and to feel the ownership, legally the company is a separate entity, and the legal standard of financial operations including owners’ compensation packages is reasonableness.