Getting Money Out of a Corporation Avoiding Double Taxation on Dividends

“You don’t want to take income into a corporation because there is double-taxation on dividends.”  This statement is only partly true and a half-truth is almost always intended to mislead. The truth is that a corporation earns money on which it is taxed; then, IF it pays out a dividend, the dividend is taxable in the hands of the recipient.  Perhaps a better way to express the truth of the matter would be: You don’t want to pay dividends out of a corporation because  they are subject to double taxation.  But there are many other ways of taking money out of a corporation, so the real question is why you would ever take it out in the form of dividends.

The primary method for taking money out of a corporation is in the form of payments for services rendered. Any such payment is a deductible expense to the corporation, reducing its taxable income. At the same time, however, such a payment becomes taxable income for the recipient.  You don’t want to receive much income personally because in all likelihood you will pay more in taxes on income received personally than the corporation would pay in retaining that income itself. On the other hand, if an individual keeps living expenses moderate and takes out only what he needs, his personal tax rate is often not much higher than that on corporate income, resulting in an effective income split and reduced overall taxation.

Keep in mind that a corporation can pay wages to any number of persons for services rendered, so it can be quite practical to have your spouse or children on the payroll, as long as they do, indeed, provide some sort of valuable service.  And before you dismiss the possibility of payments to your children, consider the potential value of intellectual property. Yes, a good idea for developing the business is compensatable as “intellectual property”. No spouse and no children and still need some income splitting? Perhaps you could acquire or pay for the “intellectual property” of another private corporation?

Don’t forget that a corporation may hold assets in the form of retained earnings.  Without stating a specific plan of development, it is considered reasonable for any corporation to keep up to $250,000 in retained earnings for future business development. Earnings may still be retained above this level without triggering the accumulated earnings surcharge prescribed by Internal Revenue Code 531-537 provided there is a plan for expansion of the business (this could include, for instance, the acquisition of another business); for paying off debts; for product liability loss reserves; for supplying loans to either customers or suppliers to maintain the viability of the business; or for the need for increased working capital (say, to acquire additional inventory for the business).