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A corporation is a taxpayer, with its own set of rules and tax rates. Those tax rates and provisions are currently a subject of discussion in Washington DC. When a corporation pays a dividend to its shareholders, it does not receive a tax deduction for the dividend, but the dividend is includible in the taxable income of its shareholders. The result is double taxation, although the rate of personal income tax on the dividends currently range from zero to 15%. Shareholders who work for the corporation are compensated by a salary, which is tax deductible to the corporation. Canada integrates its corporate and personal tax system to minimize double taxation, but that will be the subject of a future article.
Most small businesses that operate in the corporate form and meet the qualifications make an election to be an “S” Corporation. An “S” Corporation is not normally subject to the corporation income tax, but its net income is included in the taxable income of its shareholders. All of the income of the corporation is taxable to the shareholders, be it by salary or the net income of the “S” Corporation. Salary, however, is also subject to federal and perhaps state payroll taxes.
The temptation for the shareholder/employee of an “S” Corporation is to pay no or a minimal salary, thereby avoiding payroll taxes, leaving the balance of the income to be subject only to personal income taxes. This approach generally will not work. Click here to follow a link to a January 22, 2011 Wall Street Journal article on the subject.
A shareholder/employee of an “S” Corporation should be compensated by a reasonable salary. What is reasonable? That is a factor of the work performed, salary norms for the industry and the location, the expertise of the employee and the income of the business, to name a few of the factors. If you are not paying yourself a reasonable salary, you should consider revisiting the topic. The opening sentence of the article citing the “Pig Theory” of taxation is worthy of note.