Salaries vs. Dividends — How Should You Pay Yourself?
The prospect of paying yourself one day is one of the many joys that inspire people to start and build their own businesses.
As such, once your business takes hold and its cash flow stabilizes, you will need to remove some funds from the business to upgrade your lifestyle, invest, or even pursue any other business ventures you may have in mind. When that time comes, a key question will pop up: How should you pay yourself? Let’s dig into whether salaries or dividends would work better for your situation.
If you’re a member of an LLC, sole proprietor, or partner of a partnership firm, you’re likely to pay yourself using the most flexible payment method available, i.e., the owner’s draw. An Owner’s draw permits you to take out some money from your firm’s equity account any time you want.
If you own a company taxed as a C-Corp or an S-Corp, however, the rules regarding paying yourself become more rigid. This is especially true if you’re also involved in the firm’s day-to-day activities (aka a shareholder-employee.)
Salaries vs. Dividends Guide for C-Corps and S-Corps
Before analyzing each kind of corporation separately, note that as a company owner involved in the firm’s day-to-day activities, the IRS dictates that you must take a salary and pay the required income taxes on that salary. These taxes include federal unemployment taxes and FICA payroll taxes.
S-Corps (S Corporations)
S Corporations are extremely popular in America, primarily thanks to their tax advantages and special tax status with the IRS. As an owner of an S-Corp, you’ll need to pay employment tax on every salary you receive from your business. The good news, though, is you won’t have to pay employment tax on dividends you receive.
Before popping the cork on that champagne and celebrating the possibility of paying yourself a huge chunk of your compensation in dividends to avoid self-employment taxes, be aware you’ll need to abide by some stringent rules.
The IRS knows that shareholder-employees of S corporations prefer to minimize compensation payments and maximize dividends distributions to avoid payroll taxes. For that reason, the IRS introduced a law that stated business owners who also provide substantial services in their corporations have to pay themselves reasonable compensation.
Well, that depends. To find a reasonable salary range, consider how much you would be paid for your services by a different firm. Guidelines from the IRS suggest using the following factors to determine the reasonable salary you should pay yourself:
- Compensation agreements
- What a comparable business would pay you for similar services
- Any potential conflicts of interest
- Your corporation’s internal consistency of compensation
- Character and condition of the corporation
- Your roles in the company
- Your training and experience
- Dividend history
If you overpay yourself, you’ll have to pay more taxes than you need to. If you underpay yourself, on the other hand, you could face steep IRS fines. Ask a tax advisor or business valuation expert to help you estimate how much salary is reasonable.
C-Corps (C Corporations)
If you’re a shareholder-employee in a C Corporation, the salary you pay yourself is still required to meet all the guidelines the IRS has on what qualifies as reasonable compensation. Any more money you take from the business (beyond that salary) will be counted as dividends paid. This brings us to the main difference between C-Corps and S-Corps when it comes to salaries vs. dividends.
For federal tax purposes, C-Corp profits are taxed and reported on the corporation tax return. Subsequently, all after-tax profits are dispersed to stockholders as dividends get taxed again and must be reported by the shareholders on their personal tax returns.
The only way to avoid this double taxation is by applying for an S-Corp status for your corporation.
Another way you can supplement your income as a shareholder-employee of a C-Corp is through bonuses. Bonuses, like salaries, are tax-deductible expenses and will lower your company’s overall taxable income.
Be careful not to overpay yourself via bonuses or salaries because the IRS perceives excessive compensation as hidden dividends, which aren’t tax-deductible.
As you’ve seen, tax rules surrounding corporations are complex. Therefore, after mapping out all your personal expenses and knowing how much you’d like to receive as salary on an annualized basis, work with a tax professional or CPA to ensure your company stays tax-compliant.