As a small business owner, receiving compensation can take many different forms depending on your business’s legal structure and state and federal tax elections. One form of compensation is the dividend, which we’ll cover in-depth in this post.
Most people know and understand dividends by the pennies on the share they get from some of their stock holdings. However, we will look at dividends not from the passive investor point of view, but the active business owners’ point of view. For owners, the dividend can represent an additional form of compensation or a reward for a company’s positive financial performance.
For tax purposes, the first place to understand dividends is from the entity type. S corporations (S corps) and C corporations (C corps) get their names from Subchapter S and Subchapter C, respectively, of the Internal Revenue Code. S corp and C corp owners both receive dividends; however, they each have very different characteristics that also relate to tax savings.
S corp dividends
There are technically two forms of S corp dividends that an owner can receive. The first is through distributions. S corporation distributions act and work very similarly to owner’s draws that a member in a limited liability company (LLC), a partner in a partnership, or a sole proprietor receives.
Since the S corporation status is a pass-through tax entity, such as an LLC, partnership, and sole proprietorship, the S corporation earnings are passed through to the owners and taxed on the owner’s personal income tax return. S corporation shareholders or owners can take these distributions tax-free to the extent that they have basis in the company, as in how much they’ve invested, so their share of the S corporation. Any distributions in excess of a shareholder’s stock basis would be subject to long-term capital gains tax.
The second form of the S corporation dividend acts more like the traditional C corporation dividend and exists when the entity existed as a C corporation and has retained earnings prior to the conversion of the C corporation. The distributions of those earning and profits are taxed just like C corporation dividends. More on that below.
C corp dividends
The C corporation dividends act differently to the S corporation distributions due to C corp taxation. C corporations pay taxes at the corporate level and any dividends paid from the corporation are taxed again at the shareholder level, which results in double taxation. Because of this double taxation, C corporation owners may not want to receive taxable dividends as a form of compensation, particularly for smaller, closely held corporations.
However, reasonable compensation rules exist for C corporations whereby the compensation paid via wages and salaries needs to be reasonable based on the owner’s role in the corporation, financial condition of the corporation, consistency in setting compensation, comparison in compensation to other companies, and whether conflicts of interest exist in the setting of the reasonable salary. If compensation is excessive, that compensation can be reclassified as dividends to the owner. Due to the lower corporate income tax rates on business income for C corporations (currently at 21 percent), this is less of an issue than it has been in the past.
Reporting dividends and distributions
Reporting dividends and distributions to the Internal Revenue Service (IRS) are different for C corporations and S corporations.
S corps distributions are reported on Schedule K-1 (Form 1120-S), provided to each owner to reflect taxable income. It helps all of the business owners know if they have basis to take the distributions tax free when they file their individual income tax returns.
Dividends from C corporations are reported on the 1099-DIV. For smaller, closely held C corporations, it is important that you file the 1099-DIV for dividends paid, even if there is only one owner of the C corporation. Failure to file a 1099-DIV can result in a penalty starting at $50 per form. These forms are due by March 31 each year.
Because S corporations and C corporations treat dividends differently, it is important for owners to know the tax-law differences and how dividends as a form of compensation impact you and your business. Understanding how dividends work for these entities will allow you as a taxpayer to make better decisions about how to use them and avoid potential problems when filing taxes for every tax year.
