By Gerald S. Deutsch, Esq.
Glen Head, NY
The owner or part owner of a corporation who works for the corporation will generally want to draw funds from the corporation for living expenses. The funds can be drawn as a salary or a dividend or a combination of the two. Some matters to be considered relating to this are:
• Are there other stockholders that may not be active in the business that may expect to receive dividends? If all drawings are in the form of salary and no dividends are paid, then the inactive stockholders may feel they are not being treated fairly.
• A salary, while taxed as ordinary income, will, if “reasonable,” generally be deductible by the corporation. A dividend, on the other hand, while not deductible by the corporation, will be taxed at a more favorable rate to the stockholder. So, for example, if a corporation is in the 34% tax bracket and the stockholder is in the 35% tax bracket, amounts taken as salary, if deductible by the corporation will have a net cost to the payer and payee of 1% (corporation saves 34% and stockholder pays 35%). If, on the other hand, the amount is taken as a dividend, the corporation gets no deduction but the stockholder will pay tax at the rate of 15%.
• Salaries are subject to payroll taxes - FICA, FUTA, Medicare tax etc., while dividends are not subject to these taxes. And the payroll taxes are imposed on BOTH the corporation AND the stockholder (though the portion imposed on the corporation would be deductible by the corporation). In the case of an S corporation, the income is taxed not to the corporation but to the stockholder. When the income is paid out as a dividend, it is not taxed again. Therefore, it might be tempting for the stockholder of an S corporation to take no salary but instead, take his funds as a dividend. As the IRS challenges too high a salary paid to shareholders of a C corporation, so too does it challenge too low a salary paid by an S corporation that pays dividends to its stockholders. (See Rev. Rul. 74-44, 1974-1 C.B. 287, and Treasury Inspector General for Tax Administration Audit # 200130027, Reference # 2002-30-125).
• State taxation must also be taken into account as rates at which different types of income is taxed may be the same and a corporate deduction may be important for state tax purposes.
Like so many things, moderation may be the answer, or as the ancient Greeks said, “Nothing in Excess.” Salaries should be paid commensurate with the services rendered for both a C and an S corporation. Whether dividends are also paid depends on many factors including the desires of non working stockholders, restrictions on dividends imposed by lenders and, of course, the needs of the business.
For more information, in the Tax Management Portfolios, see Moran, 390 T.M., Reasonable Compensation, and in Tax Practice Series, see ¶5420, Reasonable Compensation.
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