Executive compensation and dividends, which is ultimately more advantageous? Thinking about taxes and social insurance premiums for small and medium-sized business owners
"My share is what I receive as executive compensation." - Many business owners think this way, but did you know that by effectively combining dividends, you can sometimes increase your take-home pay? This article explains the differences in tax and social insurance burdens for executive compensation and dividends, and the key points for making a decision.
What is the difference between executive compensation and dividends in the first place?
The types of burdens on both the corporation and the individual are completely different for executive compensation and dividends.
| Executive Compensation | Dividends | |
|---|---|---|
| Impact on Corporate Tax | Deductible as an expense (compresses profits) | Not deductible as an expense |
| Social Insurance Premiums | Applicable (approximately 30% combined for employer and employee) | Not applicable |
| Individual Taxes | Taxed as salary income (with salary income deduction, Income Tax Act Article 28) | Taxed as dividend income (with dividend deduction, Income Tax Act Article 92) |
The key point is that social insurance premiums apply to executive compensation but not to dividends. The burden of social insurance premiums is by no means small, and this difference significantly impacts your take-home pay.
Differences by Ratio Seen with Numerical Examples
Since it's difficult to visualize with words alone, let's compare with a simple model case.
Assumptions: Profit of a small or medium-sized corporation (before considering executive compensation and dividends) is 8 million yen, the total amount of executive compensation and dividends to the owner is 6 million yen, and retained earnings are 2 million yen.
| Executive Compensation | Dividends | Amount of social insurance premiums burden (company and individual total) | Amount of income tax and resident tax burden (company and individual total) | Owner's take-home pay (executive compensation + dividends total) |
|---|---|---|---|---|
| 6 million yen | 0 yen | Approx. 1.5 million yen | Approx. 300,000 yen | Approx. 4.2 million yen |
| 4 million yen | 2 million yen | Approximately 1 million yen | Approximately 400,000 yen | Approximately 4.6 million yen |
| 2 million yen | 4 million yen | Approximately 500,000 yen | Approximately 1.1 million yen | Approximately 4.4 million yen |
| 0 yen | 6 million yen | 0 yen | Approximately 1.9 million yen | Approximately 4.1 million yen |
Even with the same 6 million yen in returns, the take-home pay can differ by over 400,000 yen depending on the ratio. It's important to note that simply making the executive compensation zero and relying solely on dividends is not always the most profitable approach. Considering the impact on salary income deductions and corporate taxes, while keeping social insurance premiums down, there is often a "sweet spot" that offers a good balance.
Note: These are estimates based on the tax system and social insurance premium levels at the time of writing. Actual burden may vary depending on the location of the corporation, profit levels, income deductions, and enrolled social insurance, so please contact us for details.
What kind of companies should consider the advantages and disadvantages of executive compensation versus dividends?
Not all companies need to simulate the levels of executive compensation and dividends. We recommend that companies that fall into the following categories consider this. Simply switching to a dividend-focused approach solely because "social insurance premiums are not incurred" can lead to unexpected pitfalls. When designing your optimal balance, consider not only the tax burden but also these risks.
[Profit Levels]
Generally, up to a company's profit of around 8 million yen, the reduced corporate tax rate (Article 42-3-2 of the Act on Special Measures for Taxation) can be applied, making it easier to reduce the overall burden by appropriately combining dividends. On the other hand, as profits increase to 20 million or 30 million yen, social insurance premiums have an upper limit, so increasing executive compensation does not significantly increase the burden. In such cases, increasing the proportion of executive compensation over dividends tends to increase the take-home pay. In other words, the optimal combination can be reversed depending on the company's profit level, so please consider this based on your current profit level. The actual tipping point may vary depending on the company's specific situation, so please consider this as a guideline.
[Presence of Bank Loans, etc.]
When applying for a bank loan, the soundness of your financial statements is crucial, specifically maintaining a certain level of retained earnings and appropriate profit and expense levels. Shifting towards dividends by significantly reducing executive compensation can alter the profit levels and the appearance of equity on your financial statements, potentially affecting your evaluation by financial institutions. On a personal level, reducing executive compensation may decrease the amount of your future public pension benefits, and dividend income may not be evaluated as favorably as salary when applying for things like a home loan. Therefore, if you anticipate dealing with financial institutions (loans, home loans, etc.) in the future, whether for your corporation or personally, it is important to make a careful decision.
[Is there a certain level of retained earnings?]
According to the Companies Act, stock corporations must have net assets of at least 3 million yen to pay dividends (Article 458 of the Companies Act), and in certain cases, it is mandatory to set aside one-tenth of the dividend amount as a reserve (Article 445, Paragraph 4 of the Companies Act). Prioritizing dividends when retained earnings are low may make it legally impossible to pay dividends or may strain future cash flow. Additionally, it is necessary to consider how much to retain within the company and how much to distribute as returns, taking into account future business prospects such as capital investment and expansion of purchasing scale in subsequent fiscal years.
Summary
Whether executive compensation or dividends are more advantageous depends on "how much profit the company is making" and "the individual owner's situation," making it a highly personalized topic. While we have provided a general framework, achieving the optimal balance in practice requires profit simulations and precise calculations of social insurance premiums and taxes.
If you would like to know "how it applies to your specific case," please feel free to contact us at our firm. You can also review our services and fees.
