Tax Strategy Tips: Understanding Distributions, Dividends & Compensation
The Giersch Group recommends that companies review their tax strategies for the upcoming year. Many tax decisions need to be made before March 15, for calendar year companies. At the same time, most companies will have assembled their tax data for the prior year, thereby letting them review last year’s tax situation with the current year’s business plan and potential tax changes.
With this in mind, we will explore the interplay between distributions, dividends, and compensation. By understanding the difference between distributions to pay taxes and dividends, compensation may be adjusted and the compensation related taxes can be saved.
All tax matters are governed by tax laws as applied to the company’s specific facts and situation. This makes them necessarily complex. Therefore, the Giersch Group recommends companies review all tax planning with a qualified tax advisor. The tax discussion here is intended only to raise awareness of planning opportunities and should not be viewed as actionable advice.
Enterprise Structure Review
A brief review of the tax status of various legal forms of enterprises is warranted. A corporation can have the tax status of either a “C-Corp” or “S-Corp”. A corporation is automatically a C-Corp. A C-Corp is taxed at the entity level, so that any net income creates a tax paid by the company itself. An S-Corp is taxed at the shareholder level. An S-Corp is called a pass through entity, because its income in passed through to its shareholders. Any S-Corp income is reported by the company’s shareholders on their tax returns and the shareholders are responsible for any taxes.
An LLC can have the tax status of either a sole proprietorship, a partnership, or an S-Corp. Therefore an LLC is a pass through entity. The LLC’s members report on their tax return their share of the LLC’s net income. An LLC automatically starts with the tax status of a sole proprietorship or a partnership, if it has more than one member. The LLC must make an election to be taxed as an S-Corp. This election must be made in the first 2 and a half months starting the new tax year, or March 15th for calendar year LLCs.
Distributions versus Dividends
With a C-Corp, distributions to shareholders are treated as dividends to the extent of earnings and profits. Earnings and profits generally can be viewed as net income. All dividends are taxed as such to the shareholder, making this income taxed twice. Therefore, C-Corps are viewed as double tax entities; the income is taxed once at the corporate level, and then taxed again at the shareholder level via dividends.
S-Corp distributions normally do not generate additional taxes. While the S-Corp distribution is technically a dividend, because of the S-Corp pass through nature, the distribution is viewed as already taxed at the shareholder level. Therefore, only one level of tax occurs, when the shareholder reports its share of net income each year. This means that funds can be distributed from the S-Corp without further tax. LLCs that have elected to be S-Corps have this treatment as well.
LLCs that have not elected to be S-Corps are either sole proprietorships or partnerships. Neither of these entities pays dividends. The distributions are treated as distributions for all purposes. The pass through nature of these entities generally makes the distribution not subject to further tax.
For the S-Corp entity and the LLCs that are sole proprietorships or partnerships, the owners need funds to pay the taxes on the entity’s income reported at the owner level. Often these are referred to as dividends, because of the S-Corp nature of most companies. The Giersch Group recommends that the distributions to pay taxes be viewed as “distributions” rather than dividends. The company generates the income and thus should cover the tax expense on the income. Therefore, distributing funds to the owners to pay these taxes does not create any benefit to the owner. The owner is just a pass through for the payment of taxes. These distributions need to be made each quarter to pay the estimated taxes for the enterprise.
Dividends for these entities should be viewed differently from the distributions to pay taxes. A dividend is a return on investment to the owner. Therefore, a dividend represents funds the owner can retain and redeploy. Note the distinction from a distribution to pay taxes where the owner does not retain any of the funds, but turns them over to the government for taxes incurred by the enterprise’s net income.
The reason this distinction between distributions and dividends is important is both for operating planning and compensation planning, below. A company should create a return on investment. Often the Giersch Group sees smaller companies not factoring in this important element in planning for profitability of the enterprise. The return on investment supports the value that is being created in the enterprise. Therefore, dividends validate value, whereas distributions to pay taxes do not.
Dividends and Compensation
Understanding what is a dividend and its role in validating value, the interplay with compensation should be considered. Compensation is payment for services rendered. Most smaller companies have owners that work for the company. Such owners deserve to be compensated for the time, talent and efforts spent on behalf of the company.
The tax status of the company affects the compensation component. A C-Corp and S-Corp can have the owner treated as an employee. A sole proprietorship and partnership do not have the owner treated as an employee. This distinction is important. In the C-Corp and S-Corp there is the potential for separation between amounts paid for compensation and the earnings representing return on investment. This is much more difficult for the sole proprietorship and partnership.
The distinction between compensation and return on investment, or dividend, becomes essential relative to the differences in taxes for compensation versus dividends. Compensation is subject to employment taxes in addition to income tax. Employment taxes include Social Security and Medicare taxes Remember as the owner both the employer and employee pieces of Social Security should be counted. Dividends are not subject to these taxes. Therefore, causing what would be return on investment, or dividend, to be treated as compensation creates a significant additional tax burden.
The IRS understands this issue and therefore, will challenge compensation that is too low where dividends are being paid. Therefore, proper compensation planning is important. Compensation should be at market value for the activities done on behalf of the company. Proper documentation of these values is warranted. Note that this planning may be a reason for electing S-Corp status for LLCs.
Other tax planning to minimize taxes uses dividends and entity tax status. Because of the complexity and the need for tax planning to be situation specific, proper tax advice is recommended.
Articles for Further Reading
- Wasserman, Elizabeth. “How to Reduce Your Small Business Tax Bill.” 1 December 2009. www.inc.com.
- Lee, Bonnie. 5 Ways to Audit-Proof Your Tax Return. February 2009. www.entrepreneur.com.
- Tice, Carol. “Tax Time. No Dough. Don't Sweat.” 4 March 2009. www.entrepreneur.com.
- Stern, W. Rod and Carol A. Brittain. “An Overview of Deducting Business Expenses.” 12 February 2009. www.entrepreneur.com.
- My Fiscal Office, LLC. “Seven Ways to Get a Jump Start on Your Taxes.” 10 February 2010. www.myfiscaloffice.com.
- Winter, Kloman, Moter & Repp, S.C. “Be Aware of Use Tax” and “2009/2010 Tax Facts.” December 2009. www.wkmr.com.