Compensation? Or Dividend in Disguise?

When your C corporation has a profitable year, do you take more salary or pay yourself a year-end bonus? Since you are pivotal to your company's success, paying yourself more in the good years only makes sense. Increasing or decreasing your compensation from year to year based on company performance can also help manage your company's cash flow -- and the amount of income taxes it has to pay.

Tax Impact

A corporation may deduct compensation as a business expense if it is reasonable in amount. Distributing profits as salaries and bonuses can help minimize taxable corporate income, although you and other recipients will be taxed individually on the compensation you receive.

You may decide that paying additional compensation is preferable to paying out profits as dividends. Unlike compensation, dividends are not deductible. Result: Corporate profits are taxed twice -- once at the corporate level and again to the shareholders who receive the dividends.

A Word of Caution

If the amount of compensation paid to you and other shareholder-employees is deemed to be unreasonable, the IRS could challenge your company's deduction for the expense, reclassifying the "excessive" amounts as nondeductible dividends.

To potentially reduce the chances of problems with the IRS, consider these strategies:

• Divide the profits and pay out a portion as bonuses. Leave enough money in the company to generate a small amount of taxable income.
• When setting bonuses, avoid using ownership percentages to determine the amounts shareholders will receive, since that method suggests the payment of dividends.
• Adopt and follow a formal compensation plan for executives that includes bonus payments based on meeting specified financial goals.
• Earmark a portion of company profits for dividends. Individual shareholders will generally pay federal income tax on qualified dividends at a maximum rate of 20%, which is significantly lower than the maximum rate on compensation and other ordinary income.