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In this post, I will be addressing how to pay yourself as a business owner and these related subjects:
- Business owner compensation overview
- Why does Reasonable Compensation of business owners matter
- S-Corp Shareholder Employee compensation
- C Corporation Shareholder Employee compensation
- Distribution of Property & Cash to Other Shareholders
- Taxes Applicable When a Business is Sold to a New S Corp or C Corp owner
- Partnerships – Compensation, Distributions & Sale Proceeds Tax Consequences
- Sole Proprietorships Compensation, Distributions & Sale Tax Consequences
- LLC Member Compensation, Distributions & Sale Tax Consequences
Business Owner Compensation Overview
Protecting you and your business by properly distributing, reporting and paying income taxes on the income earned in your business is wise. Doing so will allow you and your business to prosper and not be thwarted by unnecessary IRS inquiries, penalties and interest.
Understanding how small business owners pay themselves or are compensated financially for their many hours of work building and growing a business is important.
Some of the compensation may be in the form of payroll checks, distribution payments of money and other assets, and ultimately from the sales proceeds after you transfer your business to a new owner. While understanding how to pay yourself as a business owner is very important, there are several forms of business owner compensation to consider.
Each business entity treats the various business owner payment methods differently, so be sure to understand which business entities permit (or require) its owners to be paid via payroll and report this income on a form W-2 each year.
Here, you will learn about a concept called ‘reasonable compensation’ which is important if you want to stay out of trouble with the Internal Revenue Service! You will learn about how income is reported to the IRS and to the business owners and their tax consequences.
And last, but not least, you will understand the types of taxes which must be paid when cash or other property is distributed to the business owner during its operation and after it is sold to a new owner.
The Compensation, Distributions and Sale Proceeds for Business Owners Overview (available for download below) is intended to help you follow along and keep the concepts you’re learning here organized.
This one-page overview covers all of the various ways business owners are compensated through their business and how each form of compensation is handled according to its type of business entity structure.
In this post, I will be guiding you through this overview to help you to gain a general understanding about the various ways you will be able to take cash and other property out of your business for your personal use.
Your CPA and/or tax preparer will likely take care of all of the details when it is time to file your business and personal income tax returns. Nevertheless, this post is intended to help you to become fully aware of the ways you may be compensated and what types of taxes will be applicable based on the type of business entity you ultimately form.
Armed with this information, we intend for you to be able to intelligently discuss this subject with your advisors and ultimately make fully-informed decisions when you form, operate and/or sell your business.
C Corporations vs. S Corporations – Compensation, Dividends, or Distributions
The income earned by your business is treated differently if it is treated for tax purposes as a C Corporation vs. an S Corporation.
A C Corporation pays federal Corporate Net Income Tax (CNIT) on its income and then pays out a dividend to its shareholders and they pay federal Personal Income Tax (PIT) on the dividends received. It’s double taxation because the same dollar of income is taxed twice–once at the corporate level and then again at the individual shareholder’s level.
An S Corporation does not pay any federal income tax on its income. Instead, the income is passed through to its shareholders and they pay Personal Income Tax on the business income attributable to their respective share of the business. It’s one level of taxation.
The reason I am reminding you that there is a difference is because of its implications when it comes to the way in which a shareholder-employee of the C Corporation and S Corporation is compensated.
When a shareholder-employee’s salary is deducted by a C Corporation, then the business net income is reduced. This means a shareholder-employee who takes as much out of the C Corporation in the form of salary may reduce the amount of income which would be subject to double taxation. Hence, most C Corporations which are closely-held by a few shareholder-employees will attempt to bonus its shareholder-employees at year end to minimize its company’s net income.
On the other hand, when a shareholder-employee’s salary is deducted by an S Corporation and the business net income is reduced, the same tax savings is not necessarily achieved. And this is because salaries are subject to several types of federal taxes. Salaries (wages and bonuses too) are subject to federal income tax, social security tax and medicare tax and the business must match the social security taxes paid as well. This makes it very expensive for a shareholder-employee to take salary out of their business. In essence, they are paying the federal income tax plus a double portion for the social security and medicare taxes!
So if you are a shareholder-employee in your S Corporation, it behooves you to minimize your salary (wages and bonuses) each year and take the profit out of the business in the form of a distribution.
And that is because distributions to shareholder-employees are not subject to the double social security and medicare taxes in an S Corporation! Instead the distributions are only subject to federal and state personal income taxes.
You can see, the tax treatment of a shareholder-employee’s compensation— albeit salary (wages and bonuses too) vs. dividends from a C Corporation or distributions from an S Corporation are very different!
The different tax treatment of the same type of income generated from a C Corporation and an S Corporation doesn’t go unnoticed by the IRS! The Internal Revenue Service clearly understands the differences very well and will consider how much a company’s shareholder-employees are paid in the form of salary (reported on a form W-2) relative to the amount of income which is reported to its shareholder-employees via a 1099-Div if it’s a C Corporation or a Form 1120S Schedule K-1.
The IRS will review a shareholder-employee’s compensation to determine if such compensation is ‘reasonable’. And they will be looking for C Corporations which are paying their shareholder-employees excessive salary and for S Corporations which are paying their shareholder-employees a salary which is below market or too low.
C Corporations vs. S Corporations – Distribution of Property & Cash to Other Shareholders
So let’s get back to distributions of cash and other property to the shareholders of corporations because how such payments are treated for tax purposes is significantly different!
When a C Corporation distributes cash to its shareholders, it is treated and reported as either a dividend or as a return of capital.
If it’s a dividend, the shareholder must pay personal income tax on the income. On the other hand, if the distribution exceeds the shareholder’s portion of the company’s Earnings and Profits on the balance sheet, then the distribution is considered a shareholder’s return of capital and the amount reduces the shareholder’s tax basis. Such a distribution would not be subject to personal income tax by the C Corporation’s shareholder.
When an S Corporation distributes cash to its shareholders, no additional reporting is necessary by the shareholder to the IRS or payment of federal income tax is due unless the amount distributed exceeds the shareholder’s AAA account.
AAA stands for the Accumulated Adjustments Account and represents the cumulative adjustments to the capital account for a given shareholder in an S Corporation. This is not something you will need to worry about as your CPA or company tax preparer will track this for you each year and report it to the IRS on your Federal 1120S tax return forms.
What’s important to understand is that the only amount of income which will need to be reported to the IRS from an S Corporation is the NET INCOME from the business. In the case of an S Corporation, the cash distributed is not added to the amount reported to the IRS on the Schedule K-1.
C Corporations vs. S Corporations – Taxes Applicable When a Business is Sold to a New Owner
The difference between the net sales proceeds (cash you get to keep) after paying federal income taxes is far and wide when you compare the sale of the assets of a C Corporation to an S Corporation!
And by now, I believe you can guess… The C Corporation shareholders end up paying twice or double the amount of income taxes the shareholders of an S Corporation pay. Not exactly double, but close.
Just as the two layers of taxes apply to a C Corporation’s income, the same holds true when the C Corporation’s assets are sold to a new business owner.
If on the other hand, the stock is sold, then the double taxation does not occur. In that case, the shareholder simply reports the sale of his shares of stock and reports their capital gain on their personal tax return (schedule D).
You may think, well that’s not so bad. I will just tell the buyer they are not going to buy the assets of my C Corporation (which would cause my company to pay tax on the capital gain and then me to pay tax on the distribution). Instead, I will tell them they must purchase my stock.
In reality, very few small businesses are sold under a stock sale method. Virtually all are sold under an asset sale method, which is worth noting as you consider which type of business you would like to form.
Keeping in mind what will happen when you eventually sell your business is a good idea. In fact, not a week goes by in my private practice that I do not have an owner of a C Corporation ask me how to fix this problem. There are ways to do so. However, resolving the double taxation in a C Corporation when it is sold is not easy, quick or cheap.
Although the subject of converting a C Corporation to an S Corporation is not something we’re discussing here, it’s important to understand that in such a scenario the federal tax treatment of distributions from an S Corporation follow a different set of rules and are dependent on the year in which the S Corporation Election was made and a number of other factors.
That’s a really nice way of saying please don’t convert your C Corporation to an S Corporation without exploring the matter thoroughly with your CPA. There is no simple way to explain the tax consequences of distributions in such a situation because the company’s underlying balance sheet must be considered and a business valuation prior to the conversion is needed.
Simply stated, please don’t do this on your own!
Partnerships – Compensation, Distributions & Sale Proceeds
In a partnership, the partners – both the general and limited partners – do not receive paychecks! This may be surprising to you.
You may also find this very appealing if you and one or more others have formed a business and you don’t want to or intend to employ others who are not a business owner. If this is the case, then you do not need to manage the process of payroll, prepare payroll reports, make payroll tax deposits, etc. or alternatively hire a payroll processing company.
Just a quick caution… If you have people working for your partnership and they are not partners in the partnership, you will need to process payroll and take care of all of the reporting and payroll tax deposits required by law.
As for the owner’s compensation in a partnership, it is reported annually on the Partnership’s tax return and it is called a ‘Guaranteed Payment’. Guaranteed Payments made to a partner are provided to compensate for their work and efforts contributed to the business.
In all cases, a Guaranteed Payment to a partner is taxed as ordinary income and is also subject to Self-Employment Taxes.
If a Limited Partner in a partnership receives cash or other property and does not work for the business, such payments are not considered to be a guaranteed payment and would only be subject to ordinary income taxes. Such a payment made to a Limited Partner reduces their capital account.
Guaranteed Payments made to its partners are deductible to the partnership and this reduces the net income that will be reported to each partner. Remember, income reported on the Federal form 1065, Schedule K-1 is reportable and taxable to the individual partners. And whether it is subject to both federal Personal Income Tax (PIT) and Self-employment Tax (SET) depends on whether the partner is a general partner or a limited partner.
Only when the distributions to a partner exceeds the partner’s individual tax basis does he or she pay personal income tax because otherwise all income is reported as either a Guaranteed Payment or as partnership income each year.
When a partnership’s assets are sold to a new owner, capital gain (or loss) tax treatment applies to the excess (or shortage) amount of cash plus the fair market value of any property distributed over the partner’s capital account.
As you can see, the sale of a partnership’s interest is much less difficult to navigate than either the C or S Corporation!
Sole Proprietorships Compensation, Distributions & Sale Tax Consequences
By far, the sole proprietorship (or single-member LLC if another tax treatment election is not made) offers the business owner the most simplistic way to compensate or distribute cash and/or property to its owner!
Similar to Partnerships, if a single owner doesn’t have any other employees, then they do not have to establish a payroll process. In such a case, they simply write out a check payable to themselves and that’s it. The sole proprietor is paid for their services.
The payments made to the sole proprietor are not deducted from the company’s income to compute net income. Instead, all of the income and expenses are tallied and the net income (if positive) or net loss (if negative) is reported on Schedule C of the sole proprietor’s federal tax return. This is the case if it is a single-member LLC as well!
There is no need to track distributions or tax basis in a sole proprietorship because a sole proprietorship is not a separate business entity.
When the assets in a sole proprietorship are sold to a new owner, the excess (or shortage) amount received over (or under) the assets’ tax basis is subject to capital gains tax on the sole proprietor’s personal tax return (Schedule D).
LLC Compensation, Distributions & Sale Tax Consequences
The treatment of an LLC Member’s compensation, distributions and LLC sale is determined by the way in which the LLC elected to be treated for federal tax purposes.
If there is more than one member in the LLC and no tax election was made by the LLC, then it’s treated as if it were a partnership.
If there is only one member of the LLC, then by default the LLC is treated as if it were a sole proprietorship.