When advising clients on business structure, CPAs must not only consider tax efficiency and liability protection, but also the rules governing compensation. Each entity has distinct limitations and opportunities for paying owners. Here is a quick guide to entity types and compensation.
- Sole Proprietorships: In a sole proprietorship, the owner is not considered an employee for federal tax purposes. As a result, owners cannot pay themselves wages and instead take money from the business through draws. Draws are not deductible by the business and do not directly affect the sole proprietor’s taxes. The sole proprietor is taxed on his or her net earnings from self employment. Self-employment tax applies to net earnings from self-employment. Retirement plan contributions are based on the sole proprietor’s earned income, not his or her draws.
- Partnerships and LLCs taxed as partnerships: Similar to sole proprietorships, partners are not W-2 employees but are instead considered self-employed. Partners typically receive money from the business through distributions, which are not considered wages and are not deductible expenses of the partnership. Partners are taxable on their distributive share of partnership income, whether or not cash is distributed. Any guaranteed payments are deductible by the partnership and taxable to the partner. Guaranteed payments and distributive shares of business income generally are subject to self-employment tax. Retirement plan contributions are based on the partner’s earned income, not his or her distributions.
- C Corporations: In addition to receiving dividends in their capacity as shareholders, owners of a C corporation can receive W-2 wages if they are employed by the business. Wages are subject to income and payroll taxes and are a deductible expense to the corporation. Dividends are not a deductible expense. The IRS expects compensation to be reasonable for the services rendered by the shareholder-employee; the IRS may view excessive compensation as an attempt to disguise dividends. (While unrelated to the amount of compensation, another common pitfall in C corporation compensation is treating W-2 employees as independent contractors whose compensation is reportable on Form 1099, rather than as wages subject to withholding on Form W-2.)
- S Corporations: S corporation shareholders who are actively involved in the business must also be compensated through reasonable W-2 wages for services; distributions cannot be used in lieu of wages. Such wages are subject to income and payroll taxes. Shareholders can also receive distributions, which generally are not subject to payroll taxes. Since undercompensating owners is a common audit trigger, CPAs should work with S corporation clients to ensure W-2 wages are benchmarked to industry norms, duties, and geographic market rates. For more than 2% shareholders, many fringe benefits, including employer-paid health insurance, are subject to income tax.
Why It Matters: An improper understanding or classification of compensation for a given entity type can result in payroll tax liabilities, penalties, and interest. Additionally, the availability of retirement plan contributions, fringe benefits, and health insurance deductions often depends on how an owner’s compensation is characterized. As CPAs, you play a critical role in guiding clients toward structures and payment strategies that seek to achieve tax efficiency and the owner’s financial goals, while ensuring companies remain compliant with IRS regulations.
by Jesse St. Cyr, Partner, Poyner Spruill
Jesse is a member of the Employee Benefits and Executive Compensation team at Poyner Spruill LLP. He represents clients before the IRS and DOL in matters involving employee benefits. Jesse has experience working with a diverse range of benefits and compensation matters and has extensive experience working with a variety of employers. Jesse is recognized by Chambers USA as a leading lawyer for Business (Employee Benefits & Executive Compensation).
