Dividends paid out as a form of compensation in an S corporation are not subject to federal and state employee taxes, such as Social Security, Medicare and unemployment taxes.The IRS has found that some unethical s-corporations had been taking advantage of this ability to avoid such taxes. Under increasing IRS scrutiny, many S corporation owners need to determine the optimum ratio of corporate income it should pay to its employees in the form of wages versus dividends.
S Corporation Compensation
The shareholders of S corporations are also most often, employees of the company. It is common for an S corporation to compensate its employee/shareholders in wages as well as dividends. The structure of an S corporation allows the owners to pass its gains and losses on to its shareholders. Doing so means that S corporation shareholders are not subject to double-taxation. Double-taxation occurs when the employee shareholders are taxed at the corporate tax level on income earned by the corporation, as well as at the personal income tax level for wages and other forms of compensation.
Income Versus Dividend Ratio
The optimum ratio the S corporation should pay out to its employee shareholders as regular income versus what it should pay out as dividends depends on what the IRS deems as reasonable. The amount of income the S corporation earns to be paid out as income or wages to its employee/shareholders should be the average salary the employee shareholder can reasonably expect to earn if he were to hold the same position at a different company in the same industry.
Optimum Income Versus Dividend Ratio Example
It is important to note that the IRS does not have an explicit definition as to what the income versus dividend should be. For example assume an employee shareholder of an S corporation is a software engineer, and that the average or reasonable salary for a software engineer is $150,000. If the employee’s share of the S corporation's income totals $200,000, then it is reasonable that she receive $150,000 of the corporation's income in the form of a wages, and the remaining $50,000 as a dividend payment. The income versus dividend ratio for the employee is 75 percent income and 25 percent dividends.
An unreasonable income versus dividend ratio for an employee/shareholder of an S corporation is if the employee/shareholder receives a small salary and a large dividend payout. For example, if the employee from the example in the previous step is paid $50,000 in wages and $150,000 in dividends, then the ratio would be 25 percent to 75 percent. This will seem unreasonable to the IRS and could cause the S corporation to be audited.