How Are Withdrawals from Your Corporation Taxed?

If you are the owner-employee of a privately held C corporation, you should know that there is more than one way to extract money from a corporation and some methods are more tax advantaged than others.

Dividend

The easiest method for making a withdrawal is to declare a dividend, but it is generally not tax efficient. The corporation will receive no deduction for the dividend payment, and you, as the recipient, will generally pay taxes on the amount you receive. However, assuming the dividend meets certain conditions, a favorable 15% tax rate (20% if you are in the 39.6% ordinary income tax bracket*) will apply.

Salary

If you take additional money out as salary, the company may deduct the compensation, assuming it is "reasonable." But you will have to pay income taxes on the salary, and both you and the company will have to pay FICA taxes. Consider the following additional alternatives.

Prior loans to the corporation

If you previously loaned the company money, you generally may be repaid with interest without having the repayment treated as a dividend. However, in certain instances, such as when a loan has not been properly documented, the IRS may attempt to recharacterize repayment amounts as dividends.

Compensation to other family members

The corporation may deduct reasonable compensation paid to your children or other family members for services actually rendered. Your family members would pay income tax on the compensation they receive at their own rates, which may be much lower than yours.

Loans from the corporation

A loan made to you by the corporation is generally not taxable, provided the loan is properly documented and you make payments of interest and principal in a timely manner.

Fringe benefits

Certain fringe benefits such as medical benefits, disability insurance, and qualifying group life insurance may be both deductible by the corporation and nontaxable to you. Generally, the company must also provide the benefits to other company employees on a nondiscriminatory basis.

* An additional 3.8% tax on net investment income could apply to high-bracket taxpayers.