This article discusses tax incentives in the classification of payments to owners.
The decision to classify cash payments to owners as wages versus profit is often affected by tax considerations. The tax code recognizes two forms of corporation, a C Corporation and an S Corporation. When a corporation of either type makes payments to owners that are not classified as wages, the payments are called dividends. Dividend payments to owners are considered distributions of corporate profits. With the C Corporation, dividend payments are taxed twice, once at the corporate level and once again at the individual level. With the S Corporation, dividend payments to owners are not taxed at the corporate level, but are taxed only on the individual owner’s tax return.
Firms operating as C Corporations have an incentive to classify payments to owners as wages to avoid double taxation. With the S Corporation, there is no need to classify dividend payments as wages to avoid double taxation. In fact, there is an incentive to avoid classifying such payments as wages, even though they are. S Corporation dividends are not subject to employment taxes, such as Social Security and Medicare taxes; wage payments are.
Example. Jeff Skewing owns and manages a small natural gas trading corporation called Endrun, Inc., which is classified as a C corporation. Assume that after all other expenses, the corporation has $100,000 available to pay Skewing. The corporation’s comptroller, Andy Fastalk, indicates that a case could be made for classifying some of the payments as wages and some as dividends. If they want to be aggressive, they might get away with classifying all as one or the other. According to Fastalk, the tax savings dictate it would be best to classify all payments as wages and none as dividends. Fastalk works up the following comparisons, which assumes a corporate tax rate of 30%, an individual tax rate of 25%, and a payroll tax rate of 15%. The payroll tax is split between the employee owner and the corporation.
Assume the same facts, except that Endrun is an S rather than a C Corporation. As you can see, the net tax advantages are exactly the opposite from a C Corporation. In the former case, tax incentives motivate a classification of payments as wages. In an S Corporation the classification of payments as dividends yields tax savings.
As you might expect, there are IRS rules to prevent corporations from manipulating facts and circumstances to achieve lower taxes. In the case of C corporations, the rules are designed to prevent corporations from classifying payments as wages if they should be classified as dividends. In the case of S corporations, the rules are designed to prevent corporations from classifying payments as dividends if they should be classified as wages. However, these rules are usually effective only in the extreme cases. For example, someone claiming $200,000 of wages for doing only a few hours of work would be a clear case. Similarly, someone claiming $200,000 as dividends and nothing as wages even though they worked 3,000 hours per year, would also be a clear case. In the more common, less extreme cases, distinguishing wages from dividends is more difficult.