Which is Better for Business Owners: Compensation or Dividends?
One of the major changes in the tax law enacted last December in the Tax Cuts and Jobs Act (TCJA) was the creation of a new deduction for “qualified business income.” As a general rule, this deduction allows individuals who are either sole proprietors or who own interests in businesses that are formed as limited liability companies, partnerships, or S corporations to deduct from their gross income an amount that may be as high as 20 percent of their share of that entity’s income.
If an individual is actively engaged in such a trade or business, that individual should consider whether it is better to receive compensation or a dividend from the business.
For instance, take an example of a married individual who is the sole owner of an S corporation that operates a small retail store, which in 2018 has gross revenues of $1,000,000, pays $300,000 in W-2 wages to its employees including $150,000 to the sole owner, and has other expenses of $600,000.
Should that owner think about lowering or raising her own wages? The S corporation’s net income that will pass through to the owner is $100,000 ($1,000,000 gross revenue less wages of $300,000 and other expenses of $600,000). In this simplified example, if the owner and the owner’s spouse have no other income, the owner’s initial taxable income will be $226,000: $150,000 of compensation and $100,000 of pass through income less the $24,000 standard deduction for the married couple.
Under the TCJA, the owner now will be entitled to an additional deduction of 20 percent of qualified business income; which is $20,000 (20 percent of $100,000 in qualified business income). Thus, after accounting for this new qualified business income deduction, the owner’s taxable income will be $206,000 ($226,000 initial taxable income less $20,000 qualified business income deduction). The owner’s federal income tax will be $38,019.
But what if the owner lowered her compensation to $100,000, increasing the S corporation’s net income that will pass through to the owner to $150,000 ($1,000,000 gross revenue less wages of $250,000 and other expenses of $600,000)?
In this instance, the owner’s initial taxable income will again be $226,000: $100,000 of compensation and $150,000 of pass through income less the $24,000 standard deduction. The additional deduction of 20 percent of qualified business income will now be increased to $30,000 (20 percent of $150,000 in qualified business income).
Now after accounting for the qualified business income deduction, the owner’s taxable income will be $196,000 ($226,000 initial taxable income less $30,000 qualified business income deduction). Accordingly, the owner’s federal income tax will be reduced to $35,619. In other words, the owner by deciding to reduce her compensation and increase her business income may be able to lower her overall income tax liability.
This analysis should only be step one of determining the right level of compensation for the owner. There are other issues to consider when deciding to increase net income of the business by lowering compensation to the owner.
For the owner, if she is contributing to a retirement plan, the amount that she may be able to contribute may be reduced since contributions to retirement plans are generally a function of compensation. Additionally, if the owner will be relying on Social Security for part of her retirement income, her eventual Social Security income will be dependent on her compensation. And lastly, there is a concern as to whether the IRS will challenge the compensation as being too low. The IRS’ interest in this matter is the Social Security and Medicare taxes that are imposed on wages.
The new deduction for qualified business income opens the door for new planning opportunities. However, the decision as to restructuring compensation and dividends is really unique to each business. The analysis has to be done based on the particular circumstances of each business. Hence, the basis for many comments that this new deduction is a gift for tax attorneys and accountants.
This article was reprinted with permission from Albuquerque Business First.
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