Dividends sound nice. You buy a stock, it pays dividends, and you're a happy investor. In fact, if you own a C corporation and it owns some GM or Disney or IBM, a whopping 70 percent of the dividends your company receives from those great investments are excluded from taxation (as long as your company owns less than 50 percent of GM, Disney or IBM, that is).
But for a privately held company, dividends are usually an expensive pain in the neck and definitely not a cause for celebration. How is this possible, you ask? Well, when your closely held company pays dividends to you and your fellow shareholders, you must pay income tax on them but your company does not enjoy a deduction for them. But that's double taxation, you say! And you're right, it is!
If you own a C corporation and you pay yourself "excess compensation" in salary or bonus in order to distribute profits from your business, the IRS can recharacterize some or all of it as a constructive dividend and render it non-deductible to your company. And, adding insult to injury, they'll likely tack on a non-deductible penalty as well.
An exception to this is a Personal Service Corporation (PSC). Businesses organized as a personal service corporation derive substantially all of their income from the labors of the service provider-owner, therefore virtually everything may be paid out as salary without risk of being reclassified as non-deductible dividends.
Another consideration is that your salary is subject to FICA taxes — Social Security tax of 12.4 percent (6.2 percent each by the employer and employee) must be paid on a salary up to $106,800 in 2009 and 2010. This amount is adjusted annually to reflect inflation, typically increasing the amount. The Medicare tax of 2.9 percent (1.45 percent each by the employer and employee) must be paid on ALL salary — whereas dividends are not subject to the tax.
So, if your corporation's tax rate is 15 percent, it might be worth it to pay at least some dividends in lieu of salary. An amount paid as dividends may be taxed twice (at the corporate tax rate, and then again at the individual tax rate) but your salary is essentially taxed twice also (at the combined FICA tax rate of 15.3 percent and again at the individual income tax rate.) But the minute your company makes more than $50,000 it gets into the 25 percent corporate bracket and payroll taxes look cheap by comparison.
Then there's the rule that if you don't pay your profits out, your company could get socked with an "accumulated earnings tax" which will make you wish you'd just paid it out in dividends and swallowed the double taxation in the first place. A C corporation can usually retain up to $250,000 without adverse consequences but a personal service corporation can only retain $150,000. Both types of entities may be permitted to retain amounts in excess of these limits if it can be demonstrated that the additional working capital meets the reasonable needs of the business; for example, if you need to retain cash to buy a new plant and equipment.
There is a happy medium to be struck in your dividend policy. If your firm is profitable, it's usually wise to declare a modest but regular dividend. Think of it as an insurance premium against future audits.