One of the most important considerations when starting a new business is determining the payment structure for yourself and your employees. One key factor in making that determination is how to minimize your tax liability. In this article, we will compare and contrast payments made via dividends in a corporation with distributions made in a closely held entity, like an LLC.

Dividends received on proceeds from C corporations are subject to “double taxation.” First, the company’s profits are taxed, and second, the shareholders who receive these profits as dividends are taxed again on those same profits. This is known as double taxation.

U.S. individuals are currently taxed on “qualifying dividends” at a preferential rate (maximum rate of 20% for higher income individuals, plus a potential additional 3.8% tax for higher income individuals on “net investment income,” which includes dividends). Qualifying dividends are dividends paid by US corporations and certain foreign corporations (including dividends paid on foreign stock listed on an established securities market in the US). To be eligible for the preferential rate, a US individual must satisfy a 61-day holding period requirement (the individual must have held the stock for at least 61 days out of the 121-day period that began 60 days before the ex-dividend date). There is a longer holding period for certain dividends on preferred stock. If the dividend is not a qualifying dividend, the dividend is subject to tax at ordinary income tax rates (which can be as high as 37%) and may also be subject to the 3.8% tax for higher income individuals on “net investment income.”

Conversely, distributions received from proceeds on the dispensation of company profits from closely held entities (such as S corporations and LLCs) are only taxed once, at the shareholder level. This is commonly referred to as the “passing through” of income and is the default tax treatment for what the Internal Revenue Code calls “partnerships,” a term that includes LLCs (also known as “disregarded entities”).

The above analysis is just a starting point in determining the appropriate payment mechanism for your company. Applicable tax laws and IRS regulations are always evolving and rarely straightforward. RR&A always recommends that you engage your CPA and lawyer to determine the current benefits of tax savings and exposures to tax liabilities for your company.