Salaries, Dividends, or Loans?

With sole proprietorships and partnerships, it makes no difference when or how much money you take out of the company, at least for tax purposes. After all, you personally pay tax on your full share of the company's income every year. These business structures don't allow for owner salaries, just withdrawals, which have absolutely no tax impact.

Corporation owners, on the other hand, can get money out of their companies in a few different ways. Each way has a different tax implication. Here, you and the IRS are at cross purposes: you want to minimize your tax bill, and it wants to maximize it. To do that, the IRS created some basic guidelines that reduce a little of the income-shifting capabilities available to corporations. With a little flexibility and planning, though, you can abide by the rules and still use them to your own tax advantage.

Some of the tax rules for corporations are quite complicated, and getting them wrong can land you in hot water with the IRS. To avoid unnecessary consequences (such as tax penalties), hire a qualified tax preparer with plenty of small-business experience.

The three main ways to get cash out of your corporation are salary, dividends, and loans. The type of corporation is a factor in the final mixture, as the tax implications for S corporation shareholders are quite different than those for C corporation shareholders. Since the name of the game is cutting the income tax bill to the bone, you want to shift as much income as possible into whichever category comes with the lowest tax rate. When you consider that you and your company are a single tax-paying unit, anything that cuts back any form of taxes leads to extra money in your hands.

The Salary Category

When it comes to managing the taxes for your business, salary can include more than a regular paycheck. This category also may encompass things such as bonuses and deferred payments, and fringe benefits as well; essentially, it's your total pay package. When you have a C corporation, you want to make that pay package as large and comprehensive as possible. S corporation owners, on the other hand, may fare better taxwise by keeping their actual salaries at a bare-bones level.

Unlike C corporation owners, S corporation shareholders don't have to deal with double taxation on dividends; they personally pay taxes on the total income of the business whether or not they take the dividends. Salary, on the other hand, is taxed at a higher rate than dividend income because it's subject to employment taxes. Looking at the S corporation and the shareholder together, more taxes will be paid all together on salary than on dividends. That makes it more beneficial for S corporation shareholders to shift the balance toward higher dividends and lower salaries.

Small C corporation owners want to do the exact opposite: put as much money into salary as possible and avoid paying themselves dividends. Here, the double taxation on dividends does come into play, with both the corporation itself paying taxes on profits and the shareholders paying taxes again on any profit distributions. Salaries, on the other hand, are completely deductible to the corporation, reducing its taxable income; only the shareholder-employee pays income tax on that money.

The Dividend Difference

Dividends are distributions of company profits, only available to corporate shareholders. The type of corporation you have, though, completely determines how these payouts are treated. With a C corporation, dividends spell double taxation, leading small-business owners to avoid using this method to get money out of the company. S corporation owners have to pay the same tax on profits whether or not they take the money out, and it can be to their advantage to maximize their dividend payouts.

If your business is set up as a C corporation, pumping as much money as possible into your salary can make the most sense taxwise when you think of you and your corporation as a couple. You want to minimize the total tax bill, including the corporate component; after all, it's your company and your money no matter what the name on the tax return says. For every dollar you take in salary and related items, the corporation gets a tax deduction. It pays taxes only on its remaining profits — the very profits used to pay dividends. When you receive dividends as a shareholder, even if you're the only shareholder, you have to pay personal income taxes on those dividends, which are already taxed to the corporation as profits. For that reason, C corporation owners (as opposed to pure investment-level shareholders) want to take as little as possible in dividends.

The situation is almost exactly the opposite for S corporation shareholders. There, salaries are a bigger tax drain than are dividends. Here's the main reason why: salaries are subject to employment taxes; dividends are not. Both forms of income show up on the owner's tax return; the only variable factor is the proportion. Yes, your salary and the related employment taxes are deductible to the business, but the business still has to pay them in the first place. A $10,000 salary can cost you and your corporation more than $1,500 in employment taxes on top of regular income taxes; dividends are subject only to income taxes, sometimes at better rates than other forms of income. By switching that $10,000 from salary to dividends, you kept that $1,500 in your pocket instead of sending it in to the IRS.

The IRS knows that C corporation owners want to avoid the dividend double taxation issue, so it put rules in place that, under certain circumstances, penalize owners for keeping profits in the company rather than distributing them and paying the extra tax. Talk to your tax adviser to make sure your corporation doesn't inadvertently fall into this tax trap.

The IRS knows all this, and it knows the strategies that owners of small corporations put into play to reduce their tax bills. For that reason, it keeps an eye on corporate shareholder-employee salaries. For S corporation shareholder-employees, the IRS looks to see that the salary isn't too low; for C corporation shareholder-employees, it checks to see that the salary isn't too high. Your best protection is paying yourself a salary that you can justify as reasonable. For example, in an S corporation, it's reasonable to keep your salary low enough to show profits. With a C corporation, it's reasonable to pay yourself the going rate for corporate CEOs.

Loans Between You and Your Corporation

While it may seem odd to lump loans in with salaries and dividends, think of them in terms of getting money out of the company without creating a big tax situation. Although there will be some taxes attached to your loan, whichever way it goes (from you to the company or vice versa), they'll be less costly than employment taxes or double taxation.

If you're wondering what part of a loan would be taxable, it's the interest; and, yes, it absolutely must be paid. Without a reasonable rate of interest attached to the loan, the IRS can choose to treat it as a dividend (particularly if you own a C corporation) or a capital contribution, neither of which would benefit your strategy.

Treat any loans between you and your corporation just as you would any other business loan. Draw up official loan documents that specify payment amounts and due dates as well as the interest rate of the loan.

  1. Home
  2. Accounting
  3. Common Small-Business Tax Snafus
  4. Salaries, Dividends, or Loans?
Visit other About.com sites: