TAX Question: Implications of paying self dividends only

[thefed]

Say I were to incorporate my business, and pay myself only dividends and no w-2 wages.

Is this possible? would this not effectively take advantage of the lower dividend tax rates for federal returns? What implications are there on the state and local level?

Just bumming out over the $$ I have to send my poor uncle sam in april

 

[thefed]

Say I were to incorporate my business, and pay myself only dividends and no w-2 wages.

Is this possible? would this not effectively take advantage of the lower dividend tax rates for federal returns? What implications are there on the state and local level?

Just bumming out over the $$ I have to send my poor uncle sam in april

maybe i should clarify....

i know in an s-corp, which i am considering, that you're supposed to take a 'reasonable salary'. Of course REASONABLE is debatable to no end, but I'd take some salary that i can prove is reasonable


How then, would the leftover profit (disbursed as a dividend to all owners...ie ME) be taxed? I know it is not subject to payroll taxes (ss and medi)...but what about the state level? anything different than regular income on either state or federal level? i thought i read somewhere that dividends are not taxed in the same way regular income is (aside from not being subject to payroll taxeS)

Thanks!

 

[Meadbh]

I do this to great advantage. But, as we live in different countries, YMMV.

 

[Niko]

maybe i should clarify....

i know in an s-corp, which i am considering, that you're supposed to take a 'reasonable salary'. Of course REASONABLE is debatable to no end, but I'd take some salary that i can prove is reasonable


How then, would the leftover profit (disbursed as a dividend to all owners...ie ME) be taxed? I know it is not subject to payroll taxes (ss and medi)...but what about the state level? anything different than regular income on either state or federal level? i thought i read somewhere that dividends are not taxed in the same way regular income is (aside from not being subject to payroll taxeS)

Thanks!

You're absolutely right that the salary must be fair and reasonable. I understand the Service is ramping up audits of S-Corps who pay no or low salaries to the owners. You should make sure to meet with a CPA to determine the most tax-advantageous way to set up your salary/distributions while complying with IRS regs. The IRS has listed factors they apply to determine whether a salary is reasonable.

My understanding (confirm with your CPA before relying on me!) is that the remaining distributions avoid FICA and Medicare but are still treated as ordinary income. Essentially, the owner's share of the corporate income and loss pass through to the owner and is reported on the shareholder's K-1, and he/she reports it as ordinary income on their personal tax return. There may be some limited circumstances in which a distribution can be treated as a capital gain.

That sound right folks?

 

[chrisdut]

I am not an accountant, but i stayed at a Holiday Inn Express last night...so I will take a stab. I think you will find that under a S-corp, what you refer to profits (to be disbursed as a dividend) will not be taxed as a dividend. Your profits will be taxed the same in the same manner as W-2 income, except it is not subject to social security/medicare taxes. One benefit of a subchapter S-corp is that you may take a section 179 deduction each year. If I were you though, I would talk to an accountant.

 

[Martha]

It is almost impossible for a small service business such as yours to get away with paying owners who work in the business anything other than a salary.

Anyway, an S corp "dividend" is really a distribution and is not a qualified dividend and you would pay ordinary income taxes on it, even if it was allowed as your salary was reasonable. So you only save the FICA.

Don't get greedy with the tax man.

 

[thefed]

It is almost impossible for a small service business such as yours to get away with paying owners who work in the business anything other than a salary.

Anyway, an S corp "dividend" is really a distribution and is not a qualified dividend and you would pay ordinary income taxes on it, even if it was allowed as your salary was reasonable. So you only save the FICA.

Don't get greedy with the tax man.

Why do you say it's almost impossible to 'get away with' paying owners a salary less than the company's profits, and the rest in a disbursement?

In my case, I average about $100/hr after expenses. To me, that is an UNreasonable rate for someone to be paid for the work I do. $20/hr is more reasonable, imho. so i figure it would make sense to pay myself wages of $20/hr...and take the rest as dividends


what am i missing?

 

[retire@40]

Why do you say it's almost impossible to 'get away with' paying owners a salary less than the company's profits, and the rest in a disbursement?

In my case, I average about $100/hr after expenses. To me, that is an UNreasonable rate for someone to be paid for the work I do. $20/hr is more reasonable, imho. so i figure it would make sense to pay myself wages of $20/hr...and take the rest as dividends

what am i missing?

If it's so unreasonable, then how come the marketplace is willing to pay you an unreasonable amount?

 

[thefed]

my understanding is that "reasonable salary" should compare to what any other similar business at arms length would pay an employee (not an owner) working the same position,the same amount of hours, with the same skill set, background etc....

My market research tells me that $$ amount is in the $15-20/hr range.

 

[thefed]

I am not an accountant, but i stayed at a Holiday Inn Express last night... One benefit of a subchapter S-corp is that you may take a section 179 deduction each year. If I were you though, I would talk to an accountant.

again, i might be wrong (usually am when it comes to taxes!!), but i thought even a sole prop can take a 179 deduction?

 

[chrisdut]

again, i might be wrong (usually am when it comes to taxes!!), but i thought even a sole prop can take a 179 deduction?

I know nothing about sole props. It may be that you can take a section 179 deduction with it.

 

[Peter]

Yes, sole proprietors can take section 179. I've been doing so for the last 15 years.

Peter

 

[ESRBob]

The Fed,
You might call the remainder you pay yourself a dividend (since it is profit left over after you pay all your expenses including your salary).

But to the IRS that S-corp distribution is ordinary income. Written into the tax code when S-corps were established.

The only 'game' is that this income doesn't have to get taxed with payroll taxes.

But you'll never get qualified dividend treatment for it-- it is ordinary income.

Make sense?

 

[thefed]

The Fed,
You might call the remainder you pay yourself a dividend (since it is profit left over after you pay all your expenses including your salary).

But to the IRS that S-corp distribution is ordinary income. Written into the tax code when S-corps were established.

The only 'game' is that this income doesn't have to get taxed with payroll taxes.

But you'll never get qualified dividend treatment for it-- it is ordinary income.

Make sense?

Yep, makes perfect sense. Thanks

I've been talking to a few cpa's in the area to get down to the details...but i want to be educated first...and the more i read about the tax laws the more confused i get...what a wierd racket the IRS has going on!

 

[ESRBob]

The Fed,
You're right -- the S-Corp is a very strange hybrid beast. Learn its ways, though, and it may be able to serve you well. One little-appreciated thing your accountant might help you on is that you can decide to be on cash or accrual basis -- accrual gives you lots of flexibility on when/how to recognize income and spread it around over different years. Might let you play tax games just like the big boys.

 

[retire@40]

The Fed,
...you can decide to be on cash or accrual basis -- accrual gives you lots of flexibility on when/how to recognize income and spread it around over different years. Might let you play tax games just like the big boys.

How would accrual basis give you greater flexibility than cash basis?

Doesn't the accrual basis force you to recognize income when it is earned whether or not you received the cash? And doesn't it force you to match expenses to revenues regardless of when you paid for the expense?

What would be the tax effect of having $100,000 in accounts receivable on Dec 31 with no payables under the accrual basis as compared to the cash basis?

Doesn't sound too flexible to me.

 

[ESRBob]

How would accrual basis give you greater flexibility than cash basis?

Doesn't the accrual basis force you to recognize income when it is earned whether or not you received the cash? And doesn't it force you to match expenses to revenues regardless of when you paid for the expense?

What would be the tax effect of having $100,000 in accounts receivable on Dec 31 with no payables under the accrual basis as compared to the cash basis?

Doesn't sound too flexible to me.

My sense is that for a small or one-person S-Corp you would have the flexibility to decide when you had actually earned the revenue if it was different from when you were actually paid. That might allow you to recognize revenue earlier or later in order to shift the income into a tax year when it was more favorable. The cash method is the one that is inflexible: you must recognize the revenue when the money is deposited in the bank.

So with your question, if you had 100k of A/R on Dec 31 you could recognize that revenue in the current year. In a big company, deciding when something actually gets put into A/R might all be figured out according to strict rules, but in your typical S-Corp, you would have more leeway to decide what those revenue recognition (and inventory valuation) rules were going to be.

 

[retire@40]

My sense is that for a small or one-person S-Corp you would have the flexibility to decide when you had actually earned the revenue if it was different from when you were actually paid...

In most cases, you would always "earn" the revenue before you are paid. An exception may be getting an advance on future book sales.

Under GAAP (FASB Statement of Financial Accounting Concepts No. 5), the revenue recognition rules are the same for everyone.

Under the cash basis, you could avoid billing for work done until the following year in order to manage your realized income.

 

[ESRBob]

There are plenty of times when you may want to speed up the recognition of revenue, too. (e.g. in order to pay taxes earlier in a year when you are in a lower tax bracket). It is a lot easier to speed up a portion of the revenue recognition than to actually get clients to deliver checks midway through projects or even near the end of projects, when 95% of the work is done but they want to drag out paying you the final 50% for months.

If you were trying to delay revenue recognition, then I agree that it is probably easier to delay sending invoices or hold onto checks and not put them in the bank. (Cash basis). Still there is a fairly fluid definition of when a project is 'done done' and when it is 'almost done but something could still blow up which would require a lot of your work time or could require refunding some or all of the monies you've already been paid' which could legitimately justify recognizing less than all the revenue now. Obviously this depends on the nature of the work-- if it is consulting/services work it may be more fluid than if it is products which you sell and which can't be returned, but services is probably more common for home-based semi-retiree kinds of businesses anyway.

Still if you're leaning against going with an S-corp, the revenue recognition benefits of an S-corp are probably not enough to turn the decision the other way.