A Powerful Device for Business Owners to Keep Taxes Low
A dividend is payment declared by a company’s board of directors (or board of managers in the case of an LLC) and given to its shareholders or owners out of the company’s current or retained earnings. Cash dividends are taxable income to the owner that receives the dividend; distributions are taxed the same way. However, because of tax law changes put in place in 2003, dividends are taxed at a maximum rate of 15%. Income, on the other hand is taxed at a maximum rate of 35%.
If a light just went off in your head, you have correctly identified a common tax saving device: if you, as an owner of an S-Corp or LLC, take some of your company’s profit in dividends rather than a salary, you can reduce your tax burden. And, dividends offer another tax advantage beyond a lower tax rate; dividends are not subject to Medicare and social security taxes.
Your Wage Will Be Subject to Scrutiny
But be warned. First, the IRS knows this trick, and if you don’t pay yourself a reasonable salary, they will call you on it, and assess you additional taxes and a penalty. If you are working at the business full time, you should be earning a reasonable salary-it isn’t reasonable for you to take all your earnings as dividends. Second, and very importantly, if you wish to avail yourself of this tax-saving device, you absolutely must secure the help of a qualified, experienced tax attorney or accountant.
If you need more guidance, note the following, the acceptance letter the IRS sends out to S Corps. Importantly, the letter dictates that “reasonable compensation generally needs to be paid”:
Notice of Acceptance as an S Corporation
We would also like to take this opportunity to inform you of your tax obligations related to the payment of compensation to shareholder-employees of S Corporations.
When a shareholder-employee of an S Corporation provides services to the S Corporation, reasonable compensation generally needs to be paid. This compensation is subject to employment taxes.
Dividends Can Be Recharacterized
Tax practitioners and Subchapter S Shareholders need to be aware that revenue ruling 74-44 states that the Internal Revenue Service (IRS) will re-characterize small business corporation dividends paid to shareholders as salary when such dividends are paid to the shareholders in lieu of reasonable compensation for services. The IRS may also re-characterize distributions other than dividend distributions as salary. This position has been supported in several recent court decisions.
Also keep in mind that with respect to LLCs, these rules are not as well tested–you might be wise to get some professional help before using these ideas.