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Which is better: bonus or dividend?

Q: I own a small corporation, and despite our slow economy we had a good year. I have rewarded my employees for their hard work with a year-end bonus and also paid some of the profits to myself. I know it is now too late, but for future reference would I have been better off paying myself a dividend? I have never taken a dividend before, but I’ve heard that I can take it tax-free. Is that true?

A: This is a wonderful question, but unfortunately I have to make a few assumptions to respond. And even with my assumptions, the “right” answer will depend on your particular facts. So please seek out a professional adviser to walk though the best course of action. But perhaps I can offer some food for thought.

I assume you are organized as an S corporation since you mentioned tax-free dividends. An S corporation typically does not pay tax on earnings (although there are situations when it can), but rather passes taxable income out to the shareholders. The shareholders are thereby responsible for paying tax on the earnings of the corporation each year. This “flow-through” income is not subject to the Social Security or Medicare taxes, which is one of the many advantages of the S corporation structure.

Normally, a shareholder needs to take “reasonable compensation” out of the S corporation, and in recent years this issue has become a target of IRS audits. The IRS wants owners of S corporations to take a high enough salary to make sure they are paying a reasonable amount of Social Security and Medicare tax, which they otherwise might avoid with an S corporation.

The determination of whether compensation is “reasonable” is quite subjective and based on a number of factors such as the employee’s duties, the employee’s ability and accomplishments, the complexities and earnings of the business, compensation of owners of similar businesses, and similar criteria.

Interestingly enough, in a regular “C corporation” the IRS is concerned that compensation of owners and officers might be too high. Besides the public policy issue of excessive compensation in a corporation, salaries paid are tax-deductible to the C corporation, but dividends are not. Consequently, since C corporations pay income tax separately from the owners, the company has motivation to pay as much as possible in salaries and take advantage of the reduced taxes from the compensation deduction.

But back to your S corporation: It is possible that if several conditions are met, an S corporation owner can also take distributions out of the company without additional taxes being incurred.

First, the owners must have taken reasonable compensation for the value of their services. Second, the distribution should reflect the expectation of a normal return on the shareholder’s investment in the company.

In effect, the owner is benefiting from earnings attributable to the skills of all the nonowner employees and the business products offered by the company, just as any investor in any company would do. The “ordering rules” for distributions from an S corporation can be complicated, so make sure you are clear on all the rules before making the distribution.

So, there very well might be advantages in taking your additional compensation in the form of a distribution in the future, but only if the reasonable compensation hurdle can be cleared. Please seek out a professional that understands the complex rules of S corporations and owner compensation to make sure you are making the right choice. And congratulations on a good year and keeping Idaho working.

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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.

About Peter G. Robbins, CPA

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