Salary Tax Issues for the Corporation

April 13, 2006

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Small business owners have a variety of withdrawal methods available to them when attempting to minimize the amount of vulnerable assets within the business. Payment of salary is the most common method, subject to certain tax issues.

In the corporation, the self-employment tax is imposed only on actual salary paid to the owners. Thus, the self-employment tax may be avoided by simply distributing earnings (i.e., dividends) to the owners rather than paying salary for services rendered. Moreover, because small business owners who operate a corporation usually will elect subchapter S corporation tax status, there will be no double tax on dividends (see our discussion of avoiding the double tax on dividends).

The advantage of paying dividends (i.e., avoiding the self-employment tax) must be weighed against the disadvantage of distributing earnings, as opposed to paying salary. In particular, payment of salary avoids the constructive fraud provisions in the Uniform Fraudulent Transfers Act (UFTA) and the stringent state corporation statutes imposed on distributions of earnings.

In addition, salary earned or accrued is exempt under many state post-judgment exemptions, as well as under federal bankruptcy exemptions, subject to certain limits. Distributions of earnings or dividends will not normally meet the definition of "wages" or "salary," and therefore will not be exempt. Thus, from an asset protection viewpoint, payment of salary offers advantages in asset exemption planning over mere distributions of earnings.

Of course, elimination of taxes is a form of asset protection (through the use of trusts, the choice of organizational form, and planning for estate taxes). Thus, small business owners must weigh the relative benefits of each form of asset protection.

As a general rule, in the early years of a business, when the entity is likely to be technically insolvent, or have no net income, and thus no earned surplus or retained earnings if it is a corporation, it may be wise to pay salary, so that the constructive fraud provisions under the UFTA or the state's corporation statute will not apply. It also qualifies the distributions under the state and federal exemption provisions in the event the business fails, resulting in litigation or, possibly, a bankruptcy filing.

As the business grows, and thrives, producing regular and substantial income, withdrawals in the form of distributions of earnings may be a better alternative than payment of salary, because these payments avoid the self-employment tax. In addition, the constructive fraud provisions will not be a real issue due to the business's sound financial position.

Overall, a better, more complementary approach, that works in both the early and more productive years of a business entity, is withdrawal of funds as loan and lease payments.