If you own a company and are also employed by that company, then you likely pay yourself wages. Wages are your regular periodic compensation for work performed as an employee. They are a company expense, paid out of company revenues, and paid whether the company is profitable or not (although some owners may waive their wages to help the company through a cash flow crisis).
Wages differ from dividends, which are your share of the company profits. Dividends are the return for your investment in the company. Dividends are not a regular expense of the company. Typically, they are only paid out when the company makes a profit during a given business period, and management decides to distribute the profit to shareholders. Unless your business is a C corporation, it makes little difference whether you pay yourself a large salary and collect smaller dividends at the end of the year or take a smaller salary and rely on the big payout later. This is because most business forms are deemed pass-through entities for tax purposes. Your primary consideration in determining how to compensate yourself will be your personal cash flow needs, and the company’s cash flow needs. However, if you own a corporation, your decision becomes more important.
What if You Own a C corporation?
You May do Better if You Pay Yourself Wages Rather than Dividends
If you own a C corporation, you may take more money home, and pay less to the taxing authorities, if you take more of your compensation in the form of wages and less in the form of dividends. A C corporation is not a pass-through entity for tax purposes and is subject to so-called double taxation.
Corporate earnings are taxed first as income to the corporation. Later, when corporate profits are paid out to shareholders in the form of dividends, they are taxed again. In contrast, wages are a deductible expense to the corporation and taxed as income only to the recipient.
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 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.
Example(s): Assume John is the sole shareholder of ABC, Inc., a C corporation that pays federal income tax at the corporate rate of 34 percent. John is in the 35 percent individual tax bracket. The corporation receives $100,000 in net income before taxes. After taxes, the remaining $66,000 is distributed to John in the form of a dividend. John pays tax on the $66,000 at a rate of 15 percent. After taxes, John has $56,100 ($66,000 – $9,900).
Assume Fred is the sole shareholder of DEF, Inc., a C corporation that also pays federal income tax at the corporate rate of 34 percent. Fred is in the 35 percent individual tax bracket. The corporation receives $100,000 in net income before taxes. Fred is paid wages of $100,000. Because wages are a deductible business expense, the corporation’s net income is reduced to zero, and no corporate income tax is due. Fred pays federal income tax on the $100,000 in wages at his 35 percent marginal rate. This leaves $65,000 for Fred after taxes ($100,000 – $35,000).
Caution: The example above is overly simplified. Wages are subject to Social Security taxes and unemployment taxes that are additional expenses to the corporation. Dividends, on the other hand, are free of these taxes. Additionally, dividends may be preferable to wages if the business does not need the salary deductions because its taxes are fully offset by other deductions.
Be Careful Not to Pay Yourself Unreasonably High Wages
In the case of C corporations, you will take more money home, and pay less to the taxing authorities, if you take more of your compensation in the form of wages, but if you pay yourself unreasonably high wages, then the plan can backfire. Pay yourself well for the services you perform, but don’t pay yourself unreasonably well. Unreasonably high salaries may be recharacterized as constructive dividends by the IRS. If the IRS determines that you are receiving distributions disguised as wages, then that compensation will be taxed as a dividend and you will be liable for interest and penalties as well.
Example(s): Frank owns a C corporation whose only asset is a sandwich shop. The shop does very well. Frank’s son runs the shop and is paid a salary of $30,000. All of the remaining employees receive minimum wage. Frank works in the shop five days a week for six hours per day, and his only job is to ring the cash register. He performs no other services for the corporation and has not taken a distribution from the corporation in several years. However, for services rendered to the company as an employee, he pays himself an annual salary of $100,000.
During an audit, the IRS finds that all compensation taken by Frank in recent years has been taken in the form of wages. They find that no other employee, including the manager, makes more than $30,000 for full-time work, while Frank makes $100,000 for part-time work. Additionally, they find that cash register attendants at similar shops make less than $25,000 per year. For these reasons, the IRS determines that Frank’s annual salary is unreasonably high, and that a portion of his wages are, in fact, dividends. These amounts are taxed as dividends, and Frank must pay interest and penalties on those amounts.
What if You Own an S Corporation?
If you own an S corporation, you may do better if you take more of your compensation in the form of dividends and less in the form of wages. S corporations are pass-through entities for tax purposes. Further, dividends paid out by an S corporation are generally treated as a tax-free return of stock basis.
If you have questions, contact the Business Experts at Henssler Financial:experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. 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. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
