Let's say in a hypothetical situation I am the sole shareholder of a C-Corporation. In year 1, let's say it makes $200,000. It pays me a salary of $60,000. The other $140,000 is profit and retained in the company. In year 2, it makes $0. My question is: can I just take $40,000 in dividends out? Or do I have to pay myself a reasonable salary first, out of the previous years profit, before I can pay dividends?
I'm just trying to come up with a way to alleviate the tax burden of a spike in income by spreading it out over multiple years. I would like to be able to just pay the dividends in year 2, since they have 0% additional tax (with a taxable income of around $44,000). Having to pay salary again would mean I pay payroll taxes and income taxes on it, on top of the 21% corporate tax rate I paid on it in year 1.
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You might want to read the thread below (very similar inquiry to yours).
Solved: Re: Paying dividends and wages in a C corp (intuit.com)
Be aware that the dividends paid out by the C-Corp is NOT deductible on the corp return so the corp pays taxes on the dividends AND the owner also pays taxes on the same dividends on their personal return.
@Critter-3 the taxpayer is contending he would pay no taxes on the dividends in the second year - they would probably be qualified dividends and thus taxed at 0% if his income is low enough.
@augh no one can say whether the IRS would agree the first-year salary of $40K is reasonable. the IRS has huge databases that it can look at that would fairly represent your corporation and see the range of salaries taken and their net income. The issue I see, if you can pay yourself a dividend, then you should be able to pay yourself a salary. However, no one can say if the IRS would even give your returns a second glance. Put another way the code does not define reasonable compensation. Rather numerous court decisions have addressed the issue with no consistent results (different tax courts). Your interest would best be served by consulting a tax pro.
I'll add a few additional comments:
Thanks. The situation I plan to be in is like this:
I have a C-Corp that owns an LLC. The LLC represents a project I am working on. I will work on that project in year 1, and let's say it does well and generates a large amount of income (let's say $500,000). The income flows to the C-Corp. I pay myself a salary of $50,000 from the C-Corp, retaining the other $450,000 in the company as profits. In year 2, I no longer work on the project, and it no longer generates any income. Can I take another $50,000 in dividends from the C-Corp, or must I take it as a salary? I would prefer the dividends, since if that's my only income, I would be at the 0% qualified dividend tax bracket. If I took it as salary, I would have to pay payroll taxes and normal income tax on top of the 21% corporate tax I already paid on the income in the first year. Since I did not work on the project in year 2, could I argue that I did not require a salary?
Now lets say in year 3 I begin working on a new project, and start a new LLC owned by the C-Corp. If that project is not yet complete, must I be paid a salary out of those retained profits from year 1 now?
If this doesn't work, is there a better way to structure this? Maybe each project is it's own C-Corp?
I'm just trying to find a way to average out my income over the years from large, inconsistent spikes of income, so that I don't hit the max tax bracket on my good year and then pay nothing in the other years. I'd like to spread it out, paying a rate each year that more closely reflects the average earnings.
What you are thinking of doing may be considered some type of tax evasion plan ... I highly recommend you seek local professional guidance from someone who understands corporate law ... a tax attorney would be wise ... for the amounts you are talking about an attorney fee would be a good expense to make sure you don't get caught later and owe thousands in penalties and interest.
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