Salary, Distribution or Guaranteed Payment?

December 5, 2015

 

An issue that we run across often when working with clients is the confusion about business organizational structure and how owners, partners or other principals are paid. This week, I've addressed this question twice, so I feel that it is something worth discussing here. 

 

The type of buisness entity you choose greatly impacts the way you are compensated and your tax situation. One of the most important items to know as a business owner, is that unless you are a C-Corporation or an S-Coroporation, you will not be taking a traditional salary where income taxes are whithheld (we will address the difference in these types of corporations in a separate blog post). 

 

You probably already know that if you are a sole-proprietor or a single member LLC, you will be taking your compensation as an Owner Draw. Those draws do not show up on the Income Statement (Profit and Loss Statement) and are not deductible by the business. They are also not the income that is taxed, but instead, the net income of the business is what will be reflected as self-employment income on the taxpayer's Schedule C and will be subject to self-employment taxes. 

 

Similarly, if you are a member of a partnership, you will receive compensation in one of two ways: Distributions and Guaranteed Payments (for the purpose of this discussion, we only be discussing cash distributions, not physcial property). A distribution is a payment based on a particular percentage of profit each partner receives as outlined in a partnership agreement. The distribution, like an owner draw, will not be deductible by the partnership. That means, it will not reduce the net income of the partnership. It will be reflected on the partner's K-1 and reported on her/his individual taxes. A guaranteed payment, on the other hand, is defined by the IRS as:

"Payments made by a partnership to a partner that are determined without regard to the partnership's income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner" (Publication 541). These payments do not have income taxes withheld in the way a salary does, but are a deductible business expense. The partner who receives it will have the amount reflected on the K-1 and will report it on her/his personal return. These amounts will be subject to self-employment taxes

 

The S-Corporation is a special hybrid that acts as a "pass-through" entity, in the same way that a sole-proprietor or partnership is, but the shareholders in this case take a reasonable salary", in addition to allowable distributions. The salaries paid to the owner and to other employees, are a deductible expense for the corporation, as are the payroll taxes. Because the corporation is paying a portion of the payroll taxes for the officer, this structure is often advantageous over a single member LLC that has not taken the S-Corporation election. 

 

Like a S-Corporation, a C-Corporation will pay a shareholder who is an employee of the business a salary; however, distributions are often paid out as dividends to shareholders (with a few exceptions) which are not tax deductible. The C-Corporation, unlike the S-Corporation, is therefore said to be subject to double taxation. A C-Corporation pays income tax based on the net income of the busiess for the fiscal year. The shareholders also then pay tax on the dividends

 

Because of the complexities involved, it is always recommended to meet with your tax advisor before deciding on a business structure as each situation is different. If you have additional questions about these topics, we are available to discuss your particular situation with you. 

 

 

 

 

 

 

 

 

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