Orange Corporation would like to transfer excess cash to its sole shareholder, Danielle, who is also an employee. Danielle is in the 28% tax bracket, and Orange is in the 34% bracket. Because Danielles contribution to the business is substantial, Orange believes that a $50,000 bonus in the current year is reasonable compensation and should be deductible by the corporation.
However, Orange is considering paying Danielle a $50,000 dividend because the tax rate on dividends is lower than the tax rate on compensation. Is Orange correct is believing that a dividendis the better choice? Why or why not?
From information provided in the problem, Orange Corporation is apparently a C corporation, meaning it pays its own tax (unlike an S Corporation that is a pass through entity).
In a C corporation, dividends distributed are subjected to what is known as the 'double tax'. That means that the dividends are not deductible by the corporation. Because they are not deductible, the corporation will effectively pay 34% tax on the amount of the dividend. That is true because taxable income will NOT be reduced for a deduction of a dividend.
The 356 word solution provides an indepth explanation in comparison of the two choice of dividend or compensation. There are reasons included for why compensation might be preferred.