NEW YORK - The recent disclosures of huge pay packages for some of the nation's prominent CEOs raise a question for small businesses as well: How much should the owner or top executives of a small firm be allowed to earn?

Technically, when you're the boss, you can draw whatever size paycheck you want. But if your business is a corporation, your compensation might be questioned by the IRS if it's too large - or too small.

If you're a sole proprietor and file Schedule C along with your 1040, there are no limits on your compensation. The income from your business flows directly to you and is taxed along with your other personal income. Your banker will want to know what you take home if you apply for a loan, but there's really no one you must answer to.

Similarly, in a traditional partnership, how the partners are compensated is up to them. They're also taxed on their 1040s.

With corporations, problems arise when the government decides that an owner or top executive is earning too much or too little, depending on whether the company is what's known as a C corporation or an S corporation. Both names come from Internal Revenue Code provisions.

In the more traditional C corporation, the company itself is taxed on what it earns, and when earnings are paid out to shareholders as dividends, the shareholders are also taxed on that income. (This is known as double taxation).

Compensation problems arise in C corporations when an owner or top executive is overpaid by IRS standards. Compensation is tax-deductible to the corporation, and it also reduces the amount of money payable as dividends to shareholders (lowering the double taxation burden). The IRS looks to see if a company is trying to skirt some of these taxes through big compensation.

In an S corporation, the company's earnings are not taxed. They're instead “passed through” to shareholders, who pay individual taxes on the income.

With an S corporation, the issue is that owners might take too little in pay. The government's concern is that companies might be trying to avoid payroll taxes, which are levied on compensation but not dividends.

Whether you have a C corporation or an S corporation, the IRS will look at what is a reasonable salary for an owner or top executive of a company in a given industry and a given geographic area.

But there are no hard and fast rules Certified public accountant Mickey Ison used an example of a company that had $5 million in revenues and $1 million in profits before the owner's compensation, which also came to a rather high $1 million.

“Who's to say that the company's making that much money wasn't the direct result of that owner's efforts and that it's not reasonable that he should take out $1 million in salary?” said Mr. Ison, managing partner of Bean & Ison in Memphis, Tenn.

As with many other financial issues, it's best to sit down with a professional to answer not just questions about taxes, but your company's overall fiscal picture. Mr. Ison said it might be better to leave money with the company for capital purposes, rather than taking it out in salary or bonus for yourself.

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