Saving Money on Taxes – Differences between Dividends, Distributions, Draws, and Guaranteed Payments

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Using and understanding the differences between these separate and distinct accounting concepts can save you a lot of money. Used improperly, they can cost you a lot of money. So let’s start at the beginning.The type of entity that you own, has everything to do with the one that is applicable to you. Dividends are associated with Regular or C-Corps Draws are associated with Sole-Proprietors Guaranteed Payments are associated with Partnerships in all their forms including General Partnerships, LLC’s, LLP’s, and the other more exotic forms of Partnership Ownership Distributions are associated with S-Corps Get to know the nomenclature. S-Corps never declare Dividends, and Sole Proprietors do not take Distributions. The names are important because the implications and therefore costs associated with the four are so different. Dividends in C-Corps Regular or C-Corporations by definition, have two separate and distinct layers of income taxes. There is always a secondary tax, even if it occurs decades later. If the Corporation shows a profit, then there is an income tax at the Company level. When the owners take that profit out, the shareholders pay a secondary income tax on their personal income tax returns. That profit is considered a dividend. So let’s use an example at some very low income tax rates. Let’s say that the company shows a $50,000 taxable profit in the given income tax year. The company will pay a 15% Federal tax and if in Illinois a 5.25% income tax. When the owner declares a dividend, a 1099 DIV will be issued to the owner for the secondary tax that is payed at standard personal income tax rates. Tax rates on dividends range anywhere from 15% to 20% at the federal level alone, so let’s just call it a combined federal & state tax rate of 20%. At this point the taxpayer pays a combined income tax rate at a minimum of 40.25% on just $50,000 of income. Many owners operating C-Corps want to get the income out of the business before the end of the year, so they will take a substantial bonus on their W-2. In many instances this can be mistake because W-2 income can be more expensive than 40%. Please see my prior post for those details. Draws and Guaranteed Payments I’ll handle both of these at the same time because they are so similar. Sole proprietors pay one of the highest amounts of tax legally allowable by law in the United States for an active trade or business. Regular income coming out of partnerships is handled in the same way because a partnership is taxed like multiple sole-proprietorships put together. You are required to pay both income and payroll taxes on your income. Regular income taxes range from 0% to 39.6% at the Federal level and another 3.7% in the state of Illinois. In addition, Self-Employment taxes are another 12.4%. So let’s be conservative and assume that you will pay a 20% federal tax, 3.7% state tax, and another 12.4% payroll tax for a total of 36.1%. And that is only if you are in a lower tax bracket. If you are in the upper income tax bracket your combined rate can be compiled starting with a federal tax of 39.6%. Distibutions in S-Corps Many will opt for an S-Status either on their Corporation of Partnership. (Yes, this is possible for a Partnership. See some of my other posts.) Why? Because there are no payroll taxes on S-Corp earnings because the Corporation will never going to turn age 65 and ask for Social Security and Medicare benefits. You do not have the secondary tax of a C-Corp, nor the additional payroll tax of a proprietorship or partnership. Owners of profitable S-Corporations are required to have a reasonable salary and to pay a reasonable payroll tax. But owners of S-Corporations, or entities such as an LLC that has elected S-Status, are not required to pay self employment tax on the entire profit of the entity. This can lead to substantial savings in each and every year of profitablilty. If you are profitable you cannot eliminate payroll taxes entirely,but they can be minimized saving 12.4% of tax on your profits. Get to know the differences between the entities and how the taxes are actually calculated to save the most money that is legally allowable. If you have difficulties in this regard, don’t hesitate to contact us. Additional accounting articles and information can be found at www.AccountingSolutionsLtd.com