Paying an employee *VS* a non-vested Investor/Owner of the company

It's far more profitable for a corporation to pay their employee in the form of dividends than it is to pay them in the form of wages.
Suppose that there is a mature company which is growing at the rate of
inflation, and its earnings are steady-state. Let's make this problem as simple as we can. 1. There are 2 identical companies: Company WagePayers and NonWagePayers (WP and nWP, respectively). 2. The companies both have a dividend yield of 7%. 3. nWP pays out all of its earnings in the form of dividends. 4. nWP does *NOT* pay a wage to its employees. 5. The employees at nWP own a lot of stocks, but they are not vested in these stocks. There is an infinity year vesting period. 6. nWP is headquartered in a country which does not pay any taxes, and their employees are in the USA.
WagePayers Company: Suppose that in WP pays their employee $60,000/year. The after tax wage is actually $48,442.50, since the taxes is $4220 + 25% of any amounts over $30,650. This information comes from http://www.irs.gov/formspubs/article/0,,id 0856,00.html This effective rate is 19.2625%. Also, the earnings of the corporation goes down by $60,000 since this amount is deducted from sales, COGS, etc. Wages are, after all, an expense.
NonWagePayers Company: nWP, on the other hand, has an astute CFO. They decide that, since the dividend tax rates is only 5%, and hence, are much less (http:// taxes.about.com/od/taxglossary/g/dividends.htm ) for these employees who don't make any salary in the technical sense of the definition.
This company figures that they still want their employees to have as much purchasing power as someone working at WP. The employee at WP earns $48,442.50 a year after taxes. The CFO of nWP realizes that a yearly dividend of $50,992.11 taxed at 5% nets exactly $48,442.50.
Moreover, he realizes that his stocks are paying out about 7% in the form of dividends. He figures out that every worker should have $728,458.71 of the stock (since $728,458.71* 7% = $50,992.11, and this after-tax is $48,442.50).
This CFO decides to allow the employees to own $728,459 of the stock, but the vesting schedule is infinity years.
The net benefit of this alternative way of compensation 1. is that the company has $60,000 more earnings per employee. This creates about $720,000-$900,000 of wealth given that the P/E ratio of a mature company is about 12x-15x. The earnings increase translates to a 12x-15x increase the valuation of the company. 2. The employee makes the same amount in both situations, after tax. This isn't a benefit, but it's not a net loss.
What are your thoughts/opinions of my analysis?
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

But you can't ~pay~ an employee dividends, you can only pay dividends to shareholders.
Also if compensation to the worker isn't reasonable, the IRS will reclassify some, or all, of the dividends as wages, assess back taxes, penalties for failure to pay, failure to file, interest, etc and so on till the company is broke.
So while you might be able to push some of what should be wage compensation to dividends, you can't go "all or nothing".
In addition, the company can not take a deduction for dividends paid, and are taxed on that profit (15% on the first $50K, 25% on the nest $25k, 34% on the next $25k) as well are the shareholders at the dividend rate. Potential tax savings isn't all that you may think it is.
That $60k up-tick in corporate profits causes a minimum of $10,000 tax to be due at the corporate level. Federal tax isn't deductible by the way.
--
Paul A. Thomas, CPA
Athens, Georgia
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
What's wrong with just paying your workers as contractors? They will make more money, pay less taxes and it will cost the employer a lot less in overhead.
--
Lubow
"draccarlawpet" < snipped-for-privacy@yahoo.com> wrote in message
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Thu, 26 Jul 2007 02:51:47 GMT, "lubow" wrote:

There are a number of hoops that you have to jump through to be a contractor vs. a worker. (I know, I have wage income and I have contracting income.)
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
industries.com says...

What is wrong with it is the IRS or other tax authoriTAH determining that those workers are really employees. And should be taxed as such. Including retroactively.
--
Get Credit Where Credit Is Due
http://www.cardreport.com /
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Aug 2, 3:15 am, snipped-for-privacy@THE-DOMAIN-IN.SIG <Usenet2...@THE-DOMAIN- IN.SIG> wrote:

I think you are referring to the Microsoft case where some contractors wanted the best of both worlds. They had been paid as contractors, but they also wanted the stock options that the employees received. The contractors won their case because Microsoft's attorneys did not have any paperwork and releases prepared.
A properly filled-out Form SS-8 will prevent IRS from ever bothering the employer. There are no statistics on this but according to our accountant it is extremely rare for IRS to reject an SS-8 application. It takes about six months for IRS to generate an approval letter, but during that waiting period, the employer is free to continue treating such workers as contractors.
In addition. Congress passed an amendment to Section 530 of the US Tax Code. It does not repeal Section 1706 but does specify that if workers in a skill category have been historically hired as contractors, they can continue to be hired as contractors without penalty.
-- Lubow.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
And this is why I call "Lowbrow"...well, "Lowbrow"...

make
And be sure to brag about "paying less taxes" as the reason for doing this on Usenet, that's the most important thing...

No, you incredible 'tard, he's talking about the many well-publicized cases the IRS and other government authorities brought against employers who futzed around with the "contractor" status of their employees...the law and case law on this issue is VERY well-known in the engineering community in particular BECAUSE...

Sure, just bring them in and tell them what to write on the form, that's the ticket...and don't forget to brag about it on Usenet, since at "common law" it's all about "mens rea"...

Congress never passed any actual change in the law, just a "procedural clarification amendment".
The law since 1987 has specifically denied relief from penalties for "job shops" that provide engineers for third-party clients (which is why the engineers here are shaking their heads about your latest moronic post), but fortunately that wouldn't apply to you, as you troll for "contractors" in the Home Depot parking lot...
--
William Ernest Reid
Post count: 715
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Lubow wrote:

I believe you are mistaken in your belief that a properly filled-out form SS-8 will protect you from the IRS.
If a person acts as an employee the IRS considers them to be an employee. This means that you, the employer, are liable for any withholding of taxes, unemployment, FICA, etc that the IRS says should have been collected -- and the penalties for not doing so in a timely manner.
Some of the criteria the IRS uses to determine if a person is an employee or, in their eyes, a valid contractor include degree of supervision, who specifies the work schedule, who decides how a task is to be performed, etc.
In order to avoid IRS problems many Fortune 500 companies will no longer engage individuals as contractors. Instead, when they require contractors they will only do business with corporations who hire contractors on a W-2 basis. Doing so results in the elimination of any liability since the intermediary corporation is doing the withholding, paying all of the taxes any other employer would pay and specifying the working conditions.
This applies equally to highly skilled professionals as well as less skilled and unskilled workers.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
says...

Possibly a good deal for an individual contractor, is to set up her own corporation. Fabulous Programming, LLC could be Jane Smith's way of controlling the accounting and taxes. And knowing exactly what is going on. And that she can qualify for opportunities to work as a business-to-business contractor, without getting swept up in a dispute that would label her as an employee.
Of course, that would require Jane Smith to be clear that she wanted to be a corporate contractor. And was willing to do the accounting and taxes that way.
--
Get Credit Where Credit Is Due
http://www.cardreport.com /
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

That's how two college drop-outs started while writing software in New Mexico for a computer manufacturer called MITS. They incorporporated calling their new enterprise, "Microsoft."
--
Lubow



Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

I am sorry for not being more detailed. What is required for official recognition of a worker's contractor status is a completed SS-8 sent to IRS with a subsequent positive IRS opinion letter. A positive IRS opinion and the SS-8 signed by both the worker and the employer is all that is required to prevent IRS (or anyone else) from subsequently challenging the contractor status of a worker. My understanding remains that IRS has never denied contractor status to anyone who had a CPA or a tax attorney prepare the SS-8 for submission to IRS.

That does not change the reality that IRS's rejection of a professionally completed SS-8 is very low. It's like asking if your investments are safe if earth collides with a giant asteroid followed by a megaton bomb dropping on the Iron Mountain depository.

OK.. for the last time. Neither of us speak for IRS. Download an SS-8, get your CPA or tax attorney to fill it out and submit it to the District Director of Internal Revenue. While you are awaiting the determination letter from IRS ask your tax attorney if there is legal precedent allowing your worker to be treated as a contractor during the waiting period for an IRS opinion.
-- Lubow
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

And most importantly, brag on Usenet that you are a "crackerjack manager of egotistical software consultants" to further solidfy the notion that you are in fact exercising "behavioral control" over your "contractors", and committing knowing fraud by claiming in writing otherwise...
--
William Ernest Reid
Post count: 719
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Jerry, do you know of even one case where IRS rejected an SS-8 application? Ask your accountant. My accountant knows of no such case.
Better still, is there even one case where a worker's status was challenged by IRS after it gave a positive ruling following the worker's SS-8 submittal?
In our company there are only two employees and I am one of them. The others are contractors. Some are incorporated, some are not.. It has never been an issue. The only time it may become an issue (so I am told) are the rare times the worker does not pay his/her taxes. It is rare because we pay by check and file a 1099 when a worker is unincorporated, as per law. IRS needs to get its money and will invariably take the route of least resistance which means getting the dough from the employer.
Even then, the laws of 1996 that provided relief to taxpayers impacted by Section 530 limits what IRS can do. For one thing, IRS cannot claim retroactive taxes nor can it levy penalties retroactively in cases that involve a worker changing from contractor to employee.
Because of the 1996 amendments, a worker is free to file an SS-8, and wait for an IRS determination (that takes around 6 months) during which time the worker remains a contractor. In the unlikely event IRS rules against the contractor, there are no penalties or retroactive taxes due during the waiting period.
I hope this clears up any misconceptions. I think I am sort-of an expert in Section 530 only because I have had to live with it for over thirty years. If you have a question, please email me at snipped-for-privacy@hotmail.com
--
Lubow



Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
In article
snipped-for-privacy@hotmail.com says...

No, actually I wasn't thinking of that particular case. Although I have heard of it.
Have you ever seen the evaluation forms for a worker challenging his/her status? I have an acquaintance who did it for both IRS and the California Franchise Tax Board.
There are questions about hours - set by the company, or by the worker? And equipment - supplied by which party? And moment to moment instructions (to an employee), compared to longer-term goals (paying a contractor for a result.) And so on and so forth. A lot of it is about operational control. How the worker interacts at the office with their supervisor.
My acquaintance's employer was either incompetent, or trying to evade Socialist Insecurity contributions, or some kind of deal with liability for accidents. It was never clear what the motivation was. Since, bizarrely enough, there was a division. Part of each paycheque was in either category - employee, or contractor. And, at the end of the year, there was a W-2 AND a 1099 for the separate proportions(!)
This resulted in problems with the quarterly tax withholding, which left the worker owing money. Inspiring the worker to point the finger at the (now-former) employer.) This person was young, and wasn't yet savvy to the issues (including the wrong assumption that an employer was withholding properly.)
The worker challenged the issue a few years later, after getting rather belated, "Fork It Over" love letter from the IRS.
The decision was that the worker was an employee, 100%. Nothing to do with stock options, and everything to do with day-to-day work structure and tax book-cooking.

"Properly filled-out Form SS-8" isn't necessarily what is true, or what is going to be submitted.

Up until there is a problem and a challenge. Remember - the US tax code is so complex that two different IRS employees may decide two radically different things. And they aren't even liable if they are wrong.
In the case that I described (and in many similar cases) the employer and the worker were now jointly and severally liable for the unpaid payroll taxes. Meaning that, either or both could be the target of IRS grabbing.
--
Get Credit Where Credit Is Due
http://www.cardreport.com /
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
draccarlawpet at snipped-for-privacy@yahoo.com wrote on 7/25/07 9:58 PM:

About equally useful to the time you figured out the P/E ratios on the S&P 500 to NINE(9) decimal places........
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

What happens when an employee leaves? Presumably the company would have to take the stock back. But if they can do that, the employee doesn't really own the stock, and the payment isn't really a dividend. If your scheme isn't illegal already the government would quickly make it illegal as soon as they found out about it.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
draccarlawpet wrote:

You left out where the money came from to buy the stock in the first place and or how the company acquired the capital that the sale of stocks would have provided. Rethink and try again.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

BeanSmart.com is a site by and for consumers of financial services and advice. We are not affiliated with any of the banks, financial services or software manufacturers discussed here. All logos and trade names are the property of their respective owners.

Tax and financial advice you come across on this site is freely given by your peers and professionals on their own time and out of the kindness of their hearts. We can guarantee neither accuracy of such advice nor its applicability for your situation. Simply put, you are fully responsible for the results of using information from this site in real life situations.