If you’re a business owner — especially if you’re an S Corporation — getting the right balance of salary and dividends is critical to the success of your business. Getting it right has a positive impact on profitability, compliance and ultimately tax liability. An imbalanced approach can result in financial inefficiencies and legal complications but a well-structured plan may lead to tax efficiency and long-term business growth. In this blog, we discuss why it’s important to balance salary and dividends, how this can be used to save on taxes, the risks of imbalance, and how 406 Consulting can assist in navigating this complex process. 1
The Significance of Salary and Dividends for Businesses
To keep a healthy financial structure, it is important to know what roles salary and dividends play in an S-Corporation. Earned income is salary, which is subject to payroll taxes and dividends are profit distributions, usually taxed at a lower rate. Salaries are a predictable and steady income stream that helps business owners pay living expenses and meet personal financial goals. However, dividends enable business owners to get their share of the company’s profitability in a tax-efficient manner. Managing these elements strategically ensures compliance with IRS guidelines, minimizes tax obligations, and keeps the financial house in order. 406 Consulting helps businesses set up their compensation plans in a way that maximizes growth and compliance.
Why It Is Important to Balance Salary and Dividends
Ensuring Compliance with IRS Regulations
S-Corp owners must take a "reasonable" salary before distributing dividends according to the IRS. If you don't do this, you can get audited and penalized, with back taxes and interest. Reasonable compensation is based on industry standards, business revenue, and job responsibilities, and the IRS looks at it that way. Here at 406 Consulting, we assist businesses in establishing the right salary levels that meet the regulations, as well as optimizing financial benefits by thorough market analysis and compliance strategies.
Optimizing Personal and Business Tax Liabilities
An unbalanced compensation structure may lead to too much or too little tax, causing additional payroll tax costs, or triggering underpayment penalties. By striking the right balance, you minimize payroll taxes and take advantage of lower tax rates on dividends. 406 Consulting helps you achieve a strategic compensation plan that aligns with personal and business financial objectives by analyzing financial statements, business performance, and tax implications.
Supporting Business Growth and Sustainability
The approach of a well-balanced salary and dividends ensures that the business has sufficient cash flow to run business and reinvest. By providing strategic planning that ensures compensation structures are aligned with long-term goals, salary ensures the stability of operational budgets, and dividends allow for reinvestment in growth opportunities. 406 Consulting ensures businesses are thriving in competitive markets.
Maximizing Retirement and Benefit Contributions
There are minimum salary levels to participate in certain retirement plans and benefits. Business owners who don’t pay themselves enough may miss out on benefits such as 401(k) contributions or healthcare coverage. 406 Consulting works with clients to design compensation strategies that support business and personal financial planning, making sure that the best benefits that support long-term financial security are available to them.
Maintaining Credibility with Financial Institutions
A well-balanced salary structure gives the company more credibility with lenders and investors. When lenders look at your loan application, they look at how much the owner is being paid (owner compensation), so it's important to be able to show a stable and reasonable salary history. 406 Consulting can help develop compensation models that will show a financially sound and compliant business image that will help you get financing for expansion and growth.
How Balancing Salary and Dividends Leads to Tax Efficiency
Minimizing Payroll Taxes
Strategically balancing salary and dividends reduces payroll tax obligations without IRS scrutiny. Business owners can spend a lot of money on payroll taxes like Social Security and Medicare. Careful structuring of compensation allows businesses to save substantially while remaining in compliance. 406 Consulting offers expert advice to help businesses accomplish both those goals through careful financial planning.
Taking Advantage of Lower Dividend Tax Rates
Dividends are usually taxed at a reduced rate than earned income and lend themselves to tax savings. Unlike salaries, dividends are a tax-efficient way to withdraw profits. We help businesses find the right split that allows them to achieve tax efficiency balancing immediate tax liabilities with long-term financial goals.
Reducing Audit Risks
Getting the right compensation avoids audit and penalty risk. S-Corps that pay low salaries and distribute high dividends are scrutinized by the IRS, who suspect tax avoidance. 406 Consulting performs periodic reviews to ensure IRS guidelines are followed and risk minimized to avoid legal trouble and compliance.
Enhancing Cash Flow Management
In a business, careful planning of how to distribute salary and dividends can keep the cash reserves sufficiently healthy while meeting tax obligations. We tailor our strategies to align financial goals with operational needs, giving businesses the liquidity to pay operational expenses while maximizing the tax position.
Improving Shareholder Value
A balanced compensation method helps to generate shareholder returns by minimizing tax liability and growth sustenance. Strategic planning that maximizes after-tax profits and reinvestment opportunities is beneficial to business owners and investors. 406 Consulting helps business and shareholders’ interests align in a way that promotes financial stability and long-term success.
Risks of Imbalance Between Salary and Dividends
Increased Tax Liabilities
Salary that is too high will increase your payroll taxes, and dividends that are too high can attract penalties. An imbalance in compensation will result in higher overall tax payments, and reduce profitability. 406 Consulting helps businesses avoid costly mistakes with proactive planning and financial analysis.
IRS Scrutiny and Audits
Unreasonably low salaries can trigger IRS audits and fines. S-Corps are closely monitored by the IRS so that they do not underpay payroll taxes. We assist businesses in creating defensible salary structures that adhere to regulatory requirements while maximizing financial benefits.
Cash Flow Challenges
Salaries can be overpaid and leave the business drained of funds, whilst dividends can be too high and can leave the business short of operational funds. Bad cash flow management can prevent future growth opportunities and prevent the business from becoming stable. Our solutions help to maintain the financial stability and sustainability of the cash flow.
Loss of Retirement and Benefits Eligibility
You can set salaries too low, but this will disqualify business owners from some key retirement plans and benefits. Contributions to tax-advantaged accounts can be limited by inadequate salary levels, which can affect long-term financial goals. 406 Consulting provides strategic salary structuring to maintain eligibility and maximize savings opportunities.
Negative Impact on Business Valuation
A business’s valuation can be negatively impacted through the use of an imbalanced approach, and this will impact investment and acquisition opportunities. Appropriate compensation models are what potential investors and buyers look for in a company's financials. We offer advisory services to help businesses become prepared for future growth and investment.
Conclusion
406 Consulting helps businesses balance salary and dividends to maximize tax efficiency while remaining in compliance and in a safe financial place. We provide customized advisory services to help you ensure that your compensation strategy promotes business goals without increasing tax liabilities and supports growth.
If you’re looking to improve your compensation structure, contact us today to help create a strategic plan that supports your business goals.
