If you own a company, and work in the company as an employee, you probably pay yourself wages. You may also receive periodic distributions of company earnings. These are called dividends.
Dividends differ from wages. Dividends are not deductible as a regular business expense. Dividends are your share of the company’s profits. They are the return for your investment in the company. Typically, dividends are paid out when the company makes a profit during a given business period and profits are distributed to shareholders. When deciding how to compensate yourself, you should consider whether it is more advantageous to receive wages or dividends. Unless you own a corporation, it makes little difference. Your primary consideration will be your personal cash flow needs and the company’s cash flow needs. If you own a corporation, your decision could affect how much money you potentially net from the corporation in a given year.
What if You Own a C corporation?
If you own a C corporation, you may do better if you take more of your compensation in the form of wages, and less in the form of dividends. C corporations are subject to so-called double taxation. Distributions are taxed first as income to the company, then again as income to the shareholder. In contrast, wages are a deductible expense for the company and only taxed as income to the individual.
Caution: Several pieces of legislation provide that dividends received by an individual shareholder from domestic corporations (and qualified foreign corporations) are taxed at long-term capital gains tax rates for taxable years beginning in 2003 through 2012. For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. Absent further legislative action, dividends will be taxed again as ordinary income beginning in 2013. As a result of changes under these laws, the advantage of wages over dividends is significantly lessened. In fact, because wages are subject to payroll taxes and dividends are not, dividends may be more advantageous than wages if your business does not need the wage deductions to offset corporate income taxes.
What if You Own an S Corporation?
Unlike a C corporation, an S corporation is a pass-through entity for tax purposes and is not subject to so-called double taxation. All earnings and profits of an S corporation are taxed to the shareholders. Earnings and profits are reported as income to the shareholders on Schedule K-1. Accordingly, regardless of whether you take your income out of an S corporation in the form of weekly wages, or in the form of K-1 income, you will pay federal and state income taxes on what you receive.
Example(s): Bob owns an S corporation. He receives an annual salary of $50,000. At the end of the year, the corporation has earnings and profits of $40,000. Bob must claim the $50,000 as wages on his Form 1040, and $40,000 as K-1 income.
Tip: K-1 income is not subject to Social Security withholding tax. Providing you do not pay yourself an unreasonably low salary, you may be able to reduce your overall Social Security withholding tax liability by reducing your annual salary and taking a larger portion of your annual earnings in the form of K-1 income.
If you receive a distribution from an S corporation in a year when the corporation has no earnings or profits, then in most cases, it will be deemed a nontaxable return of stock basis.
Example(s): John owns an S corporation. His basis in the corporation is $100,000. In a year when the corporation has no earnings or profits, the corporation pays John a distribution of $1,000. Because the corporation had no earnings or profits that year, the distribution is deemed a tax-free return of basis. John’s new basis in the company is $99,000.
If you have questions or need assistance, contact the Business Experts at Henssler Financial: 770-429-9166 orexperts@henssler.com.
Disclosures:
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
