Base Salary vs. Equity Split in an S-Corp Partnership

By Tom Speranza, J.D.

Base Salary vs. Equity Split in an S-Corp Partnership

By Tom Speranza, J.D.

Many small businesses operate as S corporations because they combine some of the best features of a corporation, such as liability protection for the shareholders, with the favorable tax treatment of a partnership.

 

An S corporation's shareholders can potentially save money on taxes by dividing their income between a salary and dividends. Learn about the benefits—and restrictions—of this salary vs. equity split.

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Two Types of Compensation

An S corp.'s shareholders may be able to save on taxes by paying themselves a base salary out of the company's income and then allocating the company's remaining annual profits to the shareholders as required by partnership tax law. The shareholders then report the two parts of their compensation on their individual tax returns based on annual documents issued by the corporation. The shareholder's salary is reported on the return as employee wages from a Wage and Tax Statement (Form W-2). The pass-through profits are reported as dividends from a Dividends and Distribution statement (Form 1099-DIV) issued by the corporation.

Base Salary Paid to Employee-Shareholders

As a general rule, if a shareholder provides services to the corporation, the company is required to treat the shareholder as an employee, meaning:

  • The corporation pays the shareholder hourly wages or a salary.
  • The corporation withholds income and employment taxes from the salary.
  • The employee compensation is a business expense the corporation can deduct when calculating its taxable income.

The Internal Revenue Service (IRS) dictates that a shareholder who serves as an officer of a corporation (someone holding an official title such as president, vice president, treasurer, or secretary) must be treated as an employee in most cases. However, a shareholder who is a director on the corporation's board does not become an employee because of his or her services on the board.

Because employee salaries qualify as a business expense and thereby reduce the company's taxable income, the IRS requires that a shareholder's compensation be “reasonable" to ensure the company isn't artificially reducing its taxable income by paying "excessive" salaries to its shareholders. The IRS considers the following factors to determine reasonable pay:

  • Duties performed by the employee
  • Volume of business handled
  • Type and amount of responsibility given to the employee
  • Complexities of the company's business
  • Amount of time required to perform the services
  • Cost of living in the company's location
  • Abilities and achievements of the employee performing the service
  • Employee's salary compared with the gross and net income of the business and the distributions to shareholders
  • Company's general policies about compensated employees (including non-shareholders)
  • Salary history for each employee

Any part of the salary that the IRS considers excessive is considered a taxable dividend paid to the employee-shareholder.

Dividends Paid to Employee-Shareholders

When a corporation distributes its income to the shareholders in the form of dividends rather than salary, the shareholders pay income tax at these significantly lower marginal rates:

  • 0 percent on any dividends that would be taxed at a 10-percent or 15-percent rate if paid as salary
  • 15 percent on any dividends that would be taxed at rates greater than 15 percent but less than 39.6 percent if paid as salary
  • 20 percent on any amount that would be taxed at a 39.6 percent rate if paid as salary

Your company's accountant or tax lawyer can advise you on how to maximize your tax savings by calibrating shareholders' salaries and dividends, while also keeping you out of trouble with the IRS.

Converting to an S-Corporation

Because S corporations can take advantage of the salary-dividend split, you may be wondering whether it makes sense to convert your existing C corporation or limited liability company (LLC) into an S corp. Among other issues, you'll need to consider whether your company can meet the specific capital structure and ownership profile required by federal law. For example:

  • An S corp. must have only one class of stock, however, it is permitted to issue non-voting shares that are otherwise identical to the voting shares.
  • An S corp. can't have more than 100 shareholders, but spouses, certain family members, and estates sometimes count as single shareholders.
  • All shareholders must either be individuals, estates, certain kinds of trusts, or certain types of entities that are exempt from federal income tax.

An existing for-profit corporation can become an S corp. by electing partnership status for tax purposes by filing an Election by a Small Business Corporation (Form 2553), signed by all of the shareholders, with the IRS. Ensure that you complete the process correctly by enlisting an online legal services provider to help you form an S corporation or convert your existing C corporation or LLC into an S corp.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.