You have been operating your business as a sole proprietor for several years. Now, as the business is growing, you are thinking about incorporating as an S corporation in order to limit your liability, avoid double taxation of corporate profits, and to make it easier to obtain financing. Your accountant suggests another advantage to consider: reduction of your liability for employment taxes. Intrigued, you ask for more information.
Shareholders can wear two heads—employee and investor
Reducing your overall employment tax liability is possible because you can be both the owner and an employee of your corporation. Shareholders can be employees of the business—this means that they can be paid salaries as employees. Employment taxes must be paid on the amounts received as salary. However, shareholders can also receive dividends from the corporation. No employment taxes need to be paid on a dividend.
Putting these two options together means that a reasonable characterization of money received as salary versus dividends can help you reduce self-employment tax liability, while still generating business expense and wages paid deductions for the corporation.
Comparison of tax liability demonstrates savings
You think that dividing your income from the business into salary and dividends sounds promising, in theory. But, you still want your accountant to show you the dollars.
Your business will have $200,000 of gross income in 2011. Your deductions total $100,000, leaving $100,000 of income that you will receive. How does having a corporation and taking $100,000 partially as salary and partially as dividends save you money?
- Sole proprietorship. You must report the entire $100,000 as earnings from self-employment as income on your Form 1040. You must also pay self-employment tax on these earnings, which will be $12,283. (You are entitled to deduct one-half of this payment from your gross income.)
- Corporation. You elect to receive a $20,000 dividend and $80,000 in salary. The total employment tax liability is $10,640. (Although your corporation receives a deduction for the employment taxes it pays.) Using the dividend/salary strategy saves you over $1,600 in employment tax liability in 2011, alone.
Using an S corporation avoids "double taxation"
In order for the salary/dividend strategy to be most effective, your corporation should be an S corporation. Unlike salary payments, dividend payments can not be deducted by a corporation to offset its current income. This means that a regular C corporation will need to pay corporate level tax on amounts it pays out as a dividend. In the example above, the tax on $20,000 would be $3,000—thereby wiping out any overall savings. By electing S corporation status, you can avoid this result. True, you will have to pay taxes on the dividend income, but your corporation will not need to do so.
Allocation of income to dividends must be reasonable
If you can save roughly $1,600 in employment taxes by paying yourself a $20,000 dividend, why not eliminate all employment taxes by dropping the salary portion and just taking a dividend? Remember that old adage: "Pigs get fed, but hogs get slaughtered?" Or, "If it seems too good to be true, it probably is?"
The IRS closely scrutinizes transactions between shareholders and their S corporation—especially if those transactions have tax avoidance potential. The more stock you own and the more control you exert over the corporation, the more likely the transaction is to be scrutinized. If the payments are challenged, the IRS will look to see if you are doing a great deal of work for the corporation. If you are doing substantial work, then the IRS will expect to see a salary that is "reasonable" for the type and quantity of work done. And, it will recharacterize the "dividend" as salary and hit the corporation with a bill for unpaid employment taxes.
Prudent use of dividends can lower employment tax bills
By paying yourself a reasonable salary (even if at the low-end of reasonable) and paying dividends at regular intervals over the year, you can greatly reduce your chances of being questioned. And, you can still lower your overall tax burden by lowering your employment tax liability.
Forming an S corporation
An S corporation is just a regular corporation that has made a special tax election with the IRS. First, you must form a corporation with state authorities. Then you need to file Form 2553 with the IRS stating you are electing S corporation status with its pass-through taxation.
Once you make this election, it can be difficult and expensive to undo. You also are bound by the corporate formalities of every corporation—holding board of directors meetings, recording the minutes, making regular filings, etc. But your reward is a lower tax bill.
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