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Scott Swanholm
Scott Swanholm

The tax effects of paying compensation or dividends in closely held
C corporations

Has anything changed since ATRA was enacted?

November 20, 2014
by Scott Swanholm, CPA

Since the American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, changed only individual tax rates but left corporate tax rates the same, this article examines the tax effects of paying dividends instead of compensation. For a large, publicly held corporation, the deductibility of compensation is seldom questioned because the corporation is usually dealing at arm’s length with its employees. The issue of unreasonable compensation arises more frequently in a closely held corporation as its owner-employees can often control whether amounts paid are compensation or dividends.

ATRA increased the top individual tax rate from 35% to 39.6% for amounts earned after Dec. 31, 2012. For 2013, this rate was imposed on taxable income in excess of the “applicable threshold” ($450,000 for married taxpayers filing jointly and surviving spouses, $425,000 for heads of households, $400,000 for singles, and $225,000 for married taxpayers filing separately). For years after 2013, these threshold amounts are adjusted for inflation, but the exhibits and figures in this article are based on 2013 tax rates. (For 2015, the inflation-adjusted amounts are $464,850 for married taxpayers filing jointly and surviving spouses, $439,000 for heads of households, $413,200 for singles, and $232,425 for married taxpayers filing separately.)

ATRA also made the 15% tax rate on qualified dividends permanent for the majority of taxpayers. For 2013 and later, the tax rate on this income is 0% for taxpayers in the 10% and 15% ordinary income tax brackets, 15% for taxpayers in the 25% to 35% income tax brackets, and 20% for taxpayers in the top income tax bracket of 39.6%. In addition, higher-income individuals are subject to an additional 3.8% tax on net investment income.

Compensation vs. dividends

Since qualified dividends are taxed at a maximum rate of 20% (or 23.8% if they are subject to the net investment income tax), it could make sense to pay out some amount of a corporation’s income in the form of dividends instead of paying compensation.

In the past, the tax strategy for most closely held C corporations has been to avoid double taxation of corporate earnings. This has been accomplished by paying salary and bonuses to shareholder-employees to “zero out” the corporation’s income, which results in having this amount taxed only once at the employee level. But these salaries and bonuses are subject to Social Security and Medicare taxes and possibly to an additional 0.9% Medicare tax for wages above a certain amount ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately).

One strategy to reduce taxes is to have shareholder-employee compensation levels that reduce corporate income to $50,000. The first $50,000 of corporate income is taxed at 15%, so total federal corporate income tax would be $7,500 ($50,000 × 15%). The remaining $42,500 is paid out to the shareholder-employee as a dividend. The exhibits below provide a comparison of paying compensation and paying dividends and the resulting cash flow to the shareholder-employee.

Exhibit 1: Zero out corporate income with wages

Wages to zero out
corporate income
Federal
tax
Medicare
tax
Total
tax
Cash
remaining
$50,000
25%
$12,500
1.45%
$725
$13,225 $36,775
$50,000
35%
$17,500
1.45%
$725
$18,225 $31,775
$50,000
39.6%
$19,800
1.45%
$725
$20,525 $29,475
Exhibit 2: $50,000 corporate income/pay out remaining as dividends
Corporate income Corporate
federal
tax
Remaining
cash for
dividends
Individual
tax on
dividends
Cash
remaining
$50,000 $7,500 $42,500
15%
$6,375
$36,125
$50,000 $7,500 $42,500
18.8%
$7,990
$34,510
$50,000 $7,500 $42,500
23.8%
$10,115
$32,385

Note: The exhibits do not consider the additional 0.9% Medicare tax on wages in excess of $200,000, nor do they consider state taxes.

Reasonable compensation considerations

Of course, care must be taken that the compensation paid to shareholder-employees would be considered “reasonable.” Reasonableness of compensation is normally based on the facts and circumstances. The courts base their decisions in this area on the application of two possible tests—a multiple-factors test (see Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983)) or a hypothetical-investor standard (see Dexsil Corp.,147 F.3d 96 (2d Cir. 1998)).

The multiple-factors test considers the following factors to determine whether compensation is reasonable:

  • Employee qualifications;
  • External comparison of employee salaries with those paid by similar companies for similar services;
  • Character and condition of the company;
  • Any conflict of interest in the relationship between the company and its employees that “would permit the company to disguise nondeductible corporate distributions as salary”; and
  • Internal consistency in how bonuses and other compensation are calculated and paid to controlling shareholders compared to nonowner management.

The hypothetical-investor standard asks “[w]hether an inactive, independent investor would be willing to compensate the employee as he was compensated” (Elliotts, 716 F.2d at 1245). An independent investor would require a certain amount of money to be retained in the corporation to be paid out as a return on the investment. In determining unreasonable compensation, courts have calculated how much a reasonable return on investment would be. The difference between this amount and the amount retained has been determined to be unreasonable compensation.

Conclusion

With the right fact pattern and considering any unreasonable compensation issues, it is possible to lower taxes and thus retain more cash for the owners of closely held corporations by paying some dividends to the owners instead of “zeroing out” the corporation’s income by paying additional compensation to the owner-employees. An owner in the 25% tax bracket (married-filing-jointly taxable income between $73,800 and $148,850) would be indifferent as the difference in the remaining cash is only $650 between the two scenarios ($36,775 – $36,125). However, as the owner’s tax bracket creeps up, the savings become larger; an owner in the 39.6% bracket would save $2,910 in taxes ($32,385 – $29,475).

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Scott Swanholm, CPA, CDFA, is a partner at Eide Bailly LLP in Fargo, N.D., and a member of the AICPA Corporations & Shareholders Taxation Technical Resource Panel.