Should Founders Take a Salary or Dividend? Tax Implications Explained
One of the most practical financial decisions every startup founder in India faces is how to take money out of their company. Should you draw a regular salary? Wait for profits and take dividends? Or use a combination of both? The answer has significant implications for your personal tax liability, your company's tax burden, cash flow management, and even how investors perceive your financial discipline. This guide breaks down the tax implications of each approach and helps you design a compensation strategy that works for your specific situation.
Understanding the Two Primary Options
Before comparing the tax implications, it is important to understand what salary and dividend mean in the context of a startup founder who is also a director of the company.
Director Salary (Remuneration)
A salary is regular compensation paid to a founder-director for their services to the company. It is treated as an employment expense for the company and as salary income for the director. The company deducts TDS, and the salary is subject to PF contributions if applicable.
Dividend
A dividend is a distribution of the company's after-tax profits to its shareholders in proportion to their shareholding. It is not a business expense for the company and comes from retained earnings after corporate tax has already been paid.
| Feature | Salary | Dividend |
|---|---|---|
| Source | Company revenue (before profit) | Company profits (after tax) |
| Deductible for Company | Yes, fully deductible | No, not deductible |
| Corporate Tax Impact | Reduces taxable profit | No reduction in taxable profit |
| Taxable for Recipient | Yes, at slab rates | Yes, at slab rates (since April 2020) |
| TDS Requirement | Required (at slab rates) | Required (10% if above Rs. 5,000) |
| PF/ESI Applicable | Yes (if thresholds are met) | No |
| Frequency | Monthly | As declared by board/shareholders |
| Companies Act Limits | Subject to Section 197 limits | Must be from distributable profits |
Tax Impact Analysis: Salary vs Dividend
The real comparison lies in the total tax cost when money flows from the company to the founder. Let us analyze this with a practical example.
Scenario: Rs. 20 Lakh Extraction from Company
| Component | Via Salary | Via Dividend |
|---|---|---|
| Amount to be received by founder | Rs. 20,00,000 | Rs. 20,00,000 |
| Company's pre-tax cost | Rs. 20,00,000 (deductible) | Rs. 26,67,000 (need to earn Rs. 26.67L to have Rs. 20L after 25% tax) |
| Corporate tax saved/paid | Rs. 5,00,000 saved (25% of Rs. 20L) | Rs. 6,67,000 paid (25% of Rs. 26.67L) |
| Founder's income tax (30% slab assumed) | Approximately Rs. 4,68,000 | Approximately Rs. 4,68,000 |
| Total tax paid (company + founder) | Approximately Rs. 4,68,000 | Approximately Rs. 11,35,000 |
| Effective combined tax rate | Approximately 23.4% | Approximately 42.5% |
Salary is significantly more tax-efficient than dividends because of the corporate tax deduction benefit. For every Rs. 1,00,000 paid as salary, the company saves Rs. 25,000 in corporate tax. For dividends, the company has already paid tax on the full profit before distribution. The combined tax burden on dividends is nearly double that of salary.
When Should Founders Take a Salary?
Taking a salary is the most tax-efficient way to extract money from your company in most situations. Here is when it makes the most sense.
- Every stage of the company: Even in the early days, take a minimum salary to establish income records and enjoy the corporate tax deduction
- When the company has revenue: As soon as the company generates revenue, a reasonable salary should be formalized
- For personal financial needs: Salary provides predictable monthly income for EMIs, rent, and personal expenses
- For tax structuring: Salary allows you to claim personal deductions like HRA, Section 80C, 80D, and NPS
- For loan eligibility: Banks require salary slips and ITR showing salary income for personal loans and home loans
Optimal Salary Structure for Founders
| Component | Percentage of CTC | Tax Benefit |
|---|---|---|
| Basic Salary | 40% to 50% | Base for HRA and PF calculation |
| HRA (House Rent Allowance) | 15% to 25% | Exempt under Section 10(13A) if paying rent |
| Special Allowance | 10% to 20% | Fully taxable but flexible component |
| LTA (Leave Travel Allowance) | 2% to 5% | Exempt for travel expenses (twice in 4-year block) |
| NPS Employer Contribution | Up to 10% | Deductible for company, partially tax-free for director |
| PF Employer Contribution | 12% of basic | Deductible for company, tax-free up to Rs. 7.5 lakh |
| Reimbursements | 3% to 5% | Tax-free if supported by actual bills |
When Should Founders Take Dividends?
Despite the higher tax cost, dividends have specific use cases where they make sense for founder compensation.
- When salary limits are reached: If the Section 197 cap on remuneration has been exhausted, dividends provide an additional extraction channel
- To reward all shareholders proportionally: If there are multiple shareholders (co-founders, investors), dividends distribute profits fairly based on ownership
- When retained earnings are substantial: Companies with large accumulated profits may distribute dividends to prevent excessive cash reserves
- In lower tax brackets: If the founder's total income is in the 5% or 20% bracket, the combined tax on dividends is lower than for high-income founders
The Hybrid Approach: Salary + Dividend
Most experienced founders and tax advisors recommend a hybrid approach that combines salary and dividends to optimize the overall tax position.
How the Hybrid Strategy Works
- Take a reasonable salary that maximizes the corporate tax deduction and allows you to claim personal tax benefits (HRA, 80C, 80D, NPS)
- Structure the salary with an optimal mix of basic pay, allowances, and reimbursements to minimize personal tax
- Declare dividends from residual profits when the company has strong retained earnings and the salary limit has been reached
- Reinvest remaining profits in the business for growth, which increases the company's valuation and your equity value over time
A founder of a company earning Rs. 1 crore in profit could take Rs. 30 lakhs as salary (reducing corporate tax by Rs. 7.5 lakhs), declare Rs. 10 lakhs as dividend from remaining profits, and reinvest Rs. 42.5 lakhs (after all taxes) back into the business. This balances personal income needs with company growth and tax efficiency.
Companies Act Compliance for Director Remuneration
The Companies Act, 2013 places specific limits and procedural requirements on how much remuneration a director can receive.
Remuneration Limits Under Section 197
| Category | Maximum Remuneration (% of Net Profits) |
|---|---|
| All Directors Combined | 11% of net profits |
| Single Managing Director / Whole-Time Director | 5% of net profits |
| Total for all Managing / Whole-Time Directors | 10% of net profits |
| Directors other than MD/WTD (commission) | 1% of net profits (if MD/WTD exists), otherwise 3% |
Remuneration When Company Has No Profits
Schedule V of the Companies Act prescribes maximum remuneration for companies with inadequate or no profits:
- Effective capital up to negative: Rs. 30 lakhs per annum
- Effective capital Rs. 5 crore and above: up to Rs. 1.20 crore per annum
- Board resolution and shareholders' special resolution required
- Central Government approval may be needed in certain cases
Alternative Compensation Methods
Beyond salary and dividends, founders have other legitimate ways to extract value from their companies.
Rent from Personal Property
If you use your personal property (home, vehicle, or equipment) for company purposes, the company can pay you rent. The rent is deductible for the company and taxable for you as income from house property or other sources. TDS at 10% applies on rent exceeding Rs. 2,40,000 per year.
Professional Fees (Through a Separate Entity)
If you provide specialized services (consulting, advisory) beyond your duties as director, you can invoice the company through a sole proprietorship or another entity. This must be a genuine, arm's length arrangement with proper documentation.
Equity Value Appreciation
The most significant wealth-building mechanism for founders is equity appreciation. As the company grows, the value of your shares increases. This wealth is only taxized when shares are sold (capital gains tax), and long-term holding provides favorable tax treatment. Many successful founders take modest salaries and focus on building equity value.
Tax Planning Checklist for Founders
- Formalize your employment: Issue an appointment letter for yourself as managing director or whole-time director
- Get board approval: Pass a board resolution approving your remuneration package
- Structure salary tax-efficiently: Include HRA, NPS, LTA, and reimbursements in your package
- File TDS on time: Ensure the company deducts and deposits TDS on your salary every month
- Maintain records: Keep all board resolutions, appointment letters, and salary breakup documents for audit purposes
- Review annually: Reassess your compensation each year based on company profitability and personal tax changes
- Consult a professional: Work with a CA or virtual CFO to optimize your compensation strategy
Conclusion
For most startup founders in India, a well-structured salary is the most tax-efficient way to draw income from the company. It provides a corporate tax deduction, regular monthly income, and the ability to claim personal tax benefits. Dividends should complement salary when the company is profitable and the salary limit has been reached.
The key is to plan proactively rather than reactively. Start with a reasonable salary from the beginning, structure it to maximize tax benefits, and adjust as the company's financial position evolves. At IncorpX, our accounting and virtual CFO services help founders design compensation strategies that are tax-efficient, compliant, and aligned with their company's growth stage.
Frequently Asked Questions
Should a startup founder take a salary or dividend?
The optimal approach depends on your company's profitability, personal tax bracket, and financial goals. In general, a salary is more tax-efficient for the company because it is deductible as a business expense, reducing corporate tax liability. Dividends are paid from after-tax profits and are taxed again in the hands of the recipient. Most founders benefit from a combination of a reasonable salary plus dividends when the company is profitable.
Is founder salary tax deductible for the company?
Yes, director remuneration is fully deductible as a business expense for the company. This reduces the company's taxable profit and consequently the corporate tax liability. The deduction is subject to compliance with the Companies Act provisions on director remuneration, including shareholder approval and limits prescribed under Section 197.
How are dividends taxed in India for founders?
Dividends received by founders are taxed as income in the hands of the recipient at their applicable income tax slab rate. Additionally, if dividend income exceeds Rs. 5,000 in a financial year, the company must deduct TDS at 10% under Section 194. The earlier Dividend Distribution Tax (DDT) payable by the company was abolished from April 1, 2020, shifting the tax burden to the shareholder.
What is the maximum salary a director can take from a private company?
Under Section 197 of the Companies Act, the total managerial remuneration cannot exceed 11% of the net profits of the company. For a single managing director or whole-time director, remuneration cannot exceed 5% of net profits (10% if there are multiple managing/whole-time directors). However, for companies with no profit or inadequate profit, Schedule V of the Companies Act prescribes specific maximum limits based on the effective capital of the company.
Can a founder take salary even if the company is making losses?
Yes, a founder-director can receive a salary even if the company is making losses or has inadequate profits. However, the remuneration is subject to limits prescribed under Schedule V of the Companies Act, 2013. These limits range from Rs. 30 lakhs to Rs. 1.20 crore per annum depending on the effective capital of the company. Approval from the board and, in some cases, shareholders is required.
What is the effective tax rate on salary vs dividend?
For a founder in the highest tax bracket (30%), salary attracts approximately 31.2% effective tax (including cess) at the individual level, but the company saves approximately 25% to 26% in corporate tax (since salary is deductible). Dividends attract the same individual tax rate but come from after-tax profits, meaning the company has already paid 25% corporate tax on the profit before distributing it. The combined effective tax on dividends is approximately 48% to 50%.
What are the compliance requirements for paying director salary?
Paying director salary requires: board resolution approving the remuneration, shareholders' resolution (ordinary or special depending on the amount), compliance with Section 197 limits, proper salary structuring with PF and TDS deductions, filing of Form MGT-14 with RoC for special resolutions, and disclosure in the annual financial statements. The company must also report director remuneration in the Directors' Report.
How does PF and ESI apply to founder salary?
If the founder-director draws a salary and the company has 20 or more employees, PF contribution is mandatory. The employee contributes 12% and the employer contributes 12% of basic salary (capped at Rs. 15,000 per month for eligibility). ESI applies if the employee count is 10 or more and the salary is below Rs. 21,000 per month. PF contributions provide additional tax benefits under Section 80C.
Can a founder receive both salary and sitting fees?
Yes, a managing director or whole-time director can receive salary, and a non-executive director can receive sitting fees. However, the same director cannot receive both managerial remuneration and sitting fees. Sitting fees are paid for attending board or committee meetings and are capped at Rs. 1 lakh per meeting (Rs. 1 lakh for independent directors of listed companies). Sitting fees are taxable as income for the director.
What is the minimum salary a founder should take?
There is no statutory minimum salary for a director in a private company. However, taking too low a salary may raise questions during tax assessments about the reasonableness of compensation. A salary should be justifiable based on the director's role, responsibilities, and market rates for similar positions. Many early-stage founders take Rs. 25,000 to Rs. 50,000 per month to maintain cash flow while establishing a formal compensation record.
How does dividend compare to share buyback for tax efficiency?
A share buyback can be more tax-efficient than dividends in certain situations. When a company buys back its own shares, the company pays a buyback tax of 20% (plus surcharge and cess) on the difference between the buyback price and the issue price. The shareholder does not pay additional tax on the buyback proceeds. For closely-held companies, buyback tax was introduced to prevent tax-efficient extraction through buybacks instead of dividends.
Should founders take a loan from the company instead?
Taking a loan from the company is not recommended as a tax planning strategy. Under Section 2(22)(e), loans or advances to shareholders holding 10% or more voting power are treated as deemed dividends and taxed accordingly. Additionally, loans to directors require compliance with Section 185 of the Companies Act (which restricts loans to directors), and interest-free loans can trigger perquisite taxation.
What happens if the company cannot afford to pay salary?
If the company is in its early stages and cash flow does not support regular salary payments, founders can defer salary and accrue it on the books. The accrued salary remains a liability of the company and is paid when cash flow improves. Alternatively, founders can work without salary initially and draw from the company once revenue stabilizes. This approach is common among bootstrapped startups.
How do angel investors view founder salaries?
Most angel investors and VCs expect founders to take a reasonable salary that covers living expenses without being excessive. Founders taking no salary raises concerns about sustainability and burn rate transparency. Founders taking inflated salaries raises concerns about cash burn and misaligned incentives. The sweet spot is a salary that is below market rate but sufficient for the founder to focus fully on the business.
What is the tax treatment of perquisites for directors?
Perquisites (non-cash benefits) provided to directors are taxable in the hands of the recipient under Section 17(2) of the Income Tax Act. Common perquisites include company car, housing, club memberships, and interest-free loans. The company must calculate the taxable value of perquisites, add it to the director's salary, and deduct TDS accordingly. Some perquisites have specified valuation rules under the Income Tax Rules.
Can a founder take consulting fees instead of salary?
A founder who is not a full-time director can provide consulting services to the company through a separate entity (sole proprietorship, LLP, or another company). The consulting fees are deductible for the company as professional fees. However, the arrangement must be genuine, at arm's length, and properly documented. The tax department may scrutinize such arrangements if they appear designed purely for tax avoidance.
How should founders structure compensation when raising funding?
When raising funding, founders should formalize their compensation structure in consultation with their investors. This typically includes a board-approved salary, ESOP vesting schedule, and clear policies on expense reimbursements. Investors expect transparency on founder compensation and may include clauses in the investment agreement specifying salary caps or requiring board approval for changes above a threshold.
What is the impact of TDS on founder salary?
The company must deduct TDS from the director's salary at the applicable income tax slab rates under Section 192. TDS must be deposited with the government by the 7th of the following month (30th April for March). The company must also file quarterly TDS returns (Form 24Q for salary). Non-compliance with TDS provisions results in penalties and interest under Sections 234E and 271C.
Can a director receive rent from the company for using personal property?
Yes, if a director rents their personal property (home, vehicle, or equipment) to the company, the rental income is taxable for the director and the rent expense is deductible for the company. The rent must be at fair market value. Under Section 194-I, the company must deduct TDS at 10% on rent payments exceeding Rs. 2,40,000 per year. This is a legitimate way to extract value from the company while providing a deductible expense.
How does interim dividend differ from final dividend?
An interim dividend is declared by the board of directors during the financial year before finalizing annual accounts. A final dividend is recommended by the board and approved by shareholders at the Annual General Meeting. Both are taxed the same way in the hands of the recipient. Companies can declare multiple interim dividends during the year, and the board must ensure adequate profits exist for each declaration.
What is the ideal salary-to-dividend ratio for founders?
There is no universal formula, but a common approach is to take 60% to 70% of total compensation as salary and the remainder as dividends when the company is profitable. The salary component should be structured to maximize deductions (HRA, NPS, reimbursements), and dividends should be distributed only when the company has sufficient retained earnings. The optimal ratio depends on the founder's personal tax bracket and the company's tax position.
Can founders take a performance bonus from their company?
Yes, founders who are managing directors or whole-time directors can receive performance-linked bonuses as part of their overall remuneration. The bonus must be within the limits prescribed under Section 197 and approved by the board (and shareholders, if required). Performance bonuses are treated as salary income and are subject to TDS. They are also deductible for the company as employee costs.
How are director reimbursements treated for tax purposes?
Legitimate business reimbursements for travel, internet, mobile, and other expenses incurred on behalf of the company are not treated as income for the director if supported by proper bills and vouchers. The company claims these as business expenses. However, if reimbursements are paid without supporting documentation, they may be treated as perquisites and become taxable for the director.
What restrictions apply to related-party transactions for founders?
Founder transactions with the company are related-party transactions under Section 188 of the Companies Act. These include salary, rent, loans, and service contracts. Related-party transactions exceeding prescribed thresholds require board approval by a resolution, and in some cases, shareholder approval through a special resolution. The transactions must be at arm's length and documented properly to withstand scrutiny.
Should founders set up a family trust for holding shares?
Setting up a family trust can be beneficial for estate planning, succession, and asset protection. However, the tax implications are complex. Income earned by a trust is taxed at the maximum marginal rate unless the trust is a specific type with identifiable beneficiaries. Shares held through a trust may complicate future fundraising and require investor approval. Consult a tax advisor and startup legal expert before structuring trust holdings.
How do different business structures affect founder compensation?
In a Pvt Ltd company, founders can take salary (deductible), dividends (taxed to recipient), or both. In an LLP, partners can receive remuneration (deductible up to prescribed limits) and profit share (tax-free to partners). In a sole proprietorship, all profits are personal income. The Pvt Ltd structure offers the most flexibility for compensation planning.
What is the gratuity obligation for founder-directors?
If a director is employed as a managing director or whole-time director for 5 or more years, they are eligible for gratuity under the Payment of Gratuity Act, 1972. Gratuity is calculated at 15 days' salary for each completed year of service. For the company, gratuity payments are deductible as business expenses. Gratuity up to Rs. 20 lakhs is tax-exempt for the director under Section 10(10).
Can a founder take salary from multiple group companies?
Yes, a founder-director serving on the boards of multiple group companies can receive remuneration from each. However, each company's remuneration must comply independently with Section 197 limits. The total income from all companies is clubbed for personal income tax purposes. Proper board approvals and compliance are required for each entity separately.
How should founders document their compensation decisions?
Compensation decisions should be documented through: board resolutions approving remuneration, shareholders' resolutions (where required), employment agreements or appointment letters, salary breakup documents, TDS compliance records, and disclosure in the annual Directors' Report. Proper documentation protects founders during tax assessments, audits, and investor due diligence.
What is the tax impact if a founder does not take any salary?
If a founder works for the company without taking salary, there is no tax obligation on non-existent income. However, this means the company loses the deduction benefit of the salary expense, resulting in higher corporate tax. From a personal perspective, the founder builds no formal income record, which can affect loan eligibility and other financial decisions. A moderate salary is generally recommended.
How do ESOPs fit into the overall founder compensation strategy?
For founders, ESOPs are more relevant for attracting and retaining key employees than for personal compensation (since founders already hold equity). However, founders can benefit by ensuring the company creates a well-structured ESOP pool that reduces the need for high cash salaries to attract talent, thereby preserving cash for growth. The ESOP pool typically dilutes founder equity by 10% to 15%.
What are the Section 40A(2) implications for founder salary?
Section 40A(2) allows the Assessing Officer to disallow excessive or unreasonable payments made to specified persons, including directors and their relatives. If the founder's salary is considered unreasonable compared to the fair market value of the services rendered, the excess amount can be disallowed as a business deduction. Ensuring market-rate compensation and proper documentation prevents 40A(2) scrutiny.
Can a Non-Executive Director receive a salary?
A Non-Executive Director cannot receive a salary or remuneration in the traditional sense. They can only receive sitting fees for attending board and committee meetings (capped at Rs. 1 lakh per meeting) and commission as approved by shareholders. If a Non-Executive Director provides professional services beyond board duties, they can be compensated through a separate professional services agreement.
How does the Companies Act regulate director compensation?
The Companies Act, 2013 regulates director compensation through Section 197 (remuneration limits), Section 198 (net profits calculation), Schedule V (remuneration in case of inadequate profits), and Section 188 (related-party transaction approvals). Private companies have more flexibility than public companies, and certain provisions are relaxable if the company passes appropriate resolutions and files with the RoC.
What is the best compensation strategy for bootstrapped startups?
For bootstrapped startups with limited cash flow, the recommended approach is: keep founder salary minimal (Rs. 15,000 to Rs. 30,000 per month) to maintain a formal income record, accrue additional salary on books to be paid later when cash flow improves, avoid dividends until the company has consistent profitability, and focus on building equity value rather than extracting cash. As revenue grows, gradually increase salary to market-competitive levels.
How should compensation change as the startup scales?
As the startup scales and raises funding, founder compensation should evolve: pre-revenue stage (minimal salary, no dividends), seed stage (modest salary approved by board), Series A (market-rate salary with investor alignment), growth stage (competitive salary with performance bonuses), and maturity stage (full market compensation with dividends from profits). Each stage should align compensation with the company's financial capacity and investor expectations.
