Taxes: Distributions, Dividends, and Compensation
Every February Cathedral 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, this year’s February Topic of the Month 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, Cathedral 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 CCorp. 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
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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.
Planning
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. Cathedral
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 Cathedral 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.
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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 at 15.3%1 and Medicare taxes at 2.9%2 for a total of 19.2% in taxes over income
taxes.(Note: Wages in excess of $106,800 are subject to the 1.45% Medicare tax.)3 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. Today Social Security stops at $106,8004 for 2010, but the worry is that the Social
Security limit will be raised or removed all together in the near future even as it is for Medicare.
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
1. Wasserman, Elizabeth. “How to Reduce Your Small Business Tax Bill.” 1 December
2009. www.inc.com.
2. Lee, Bonnie. 5 Ways to Audit-Proof Your Tax Return. February 2009.
www.entrepreneur.com.
3. Tice, Carol. “Tax Time. No Dough. Don't Sweat.” 4 March 2009.
www.entrepreneur.com.
4. Stern, W. Rod and Carol A. Brittain. “An Overview of Deducting Business Expenses.”
12 February 2009. www.entrepreneur.com.
5. My Fiscal Office, LLC. “Seven Ways to Get a Jump Start on Your Taxes.” 10 February
2010. www.myfiscaloffice.com.
6. Winter, Kloman, Moter & Repp, S.C. “Be Aware of Use Tax” and “2009/2010 Tax
Facts.” December 2009. www.wkmr.com.
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the New York
Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
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SSA Publication No. 05-10022, January 2010, ICN 454900
SSA Publication No. 05-10022, January 2010, ICN 454900
Winter, Kloman, Moter, & Repp, S.C. Update: December 2009. Volume 34, Number 4.
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SSA Publication No. 05-10022, January 2010, ICN 454900
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