When to take dividends in lieu of salary as a business owner
Surprisingly, you may end up better off this year by having your corporation forgo a tax deduction.
Strategy: Make this a “dividend year.” In other words, instead of receiving income in the form of tax-deductible wages, arrange to have the company pay out dividends to yourself.
If you’re in a high tax bracket and your company is in a low one, which is often the case for small business owners, you’ll save tax overall due to the current tax break for qualified dividends.
Here’s the whole story: Under the extended Bush tax cuts, dividends from domestic companies are generally taxed at a maximum 15% tax rate in 2012.
Beginning in 2013, this tax break is scheduled to expire. Barring new legislation, dividends will be taxed at ordinary income rates reaching as high as 39.6% next year (up from a top rate of 35% in 2012).
Although wages are deductible by a C corporation and dividends are not, a business owner may benefit by shifting wages to dividends if he or she is in a higher tax bracket in 2012. In addition to the tax break for dividends, you avoid payroll taxes on amounts paid as dividends.
Example: You’re in the 35% tax bracket and you receive an annual $100,000 salary from your C corporation business. The company is in the 25% bracket. If it pays $10,000 to you in dividends instead of wages, your income tax is $1,500 (15% of $10,000) as opposed to $3,500 (35% of $10,000), or $2,000 less.
Also, you save $565 in payroll tax (5.65% of $10,000), while the company saves $765 (7.65% of $10,000). Total savings: $3,330 ($2,000 + $565 + $765).
Even though your company loses a $2,500 deduction (25% of $10,000), you and your company together still come out $830 ahead overall ($3,330 – $2,500).
Tip: This strategy doesn’t work for personal service corporations required to pay tax at a flat 35% rate.
What’s more, due to the new 3.8% Medicare surtax under the new health care law, you could be paying an effective top tax rate of 43.4% in 2013.
