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

By Jeff Clements

Business owners are able to also work in their business as employees. This means they can earn wages or base salary, as well as their share of net profit from the business. An S corporation is a special type of business entity that has a favorable tax treatment by the Internal Revenue Service. As part of its pass-through tax status, it is required to treat all of its owners equally. However, there is no requirement that its owners work as paid employees for the S corporation in equal amounts or for equal compensation, or at all.

S Corporation Election

By default, an S corporation starts out as a regular C corporation. After the company is formed, its shareholders may make a unanimous election with the IRS to be taxed as a disregarded entity. This is often done in small businesses that wish to avoid double taxation of the profit from the business. Nonetheless, it still is a legal corporation that is subject to the corporation statutes of the state in which it was initially formed.

Partnership Treatment

Shareholders of an S corporation are entitled to share in the company's profits and losses in proportion to the equity split or relative ownership interest. As with a partnership, income taxes are not paid at the entity level, but instead are paid by the individual owners via their personal income taxes. Thus, for most practical purposes, small S corporations behave very much like general partnerships.

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Shareholders as Base Salary Employees

An S corporation is an independent business entity and shareholders can work for the company as paid employees. Any compensation, such as base salary or wages, paid to a shareholder of an S corporation who works for the company as an employee is considered a business expense and comes out of the company's gross income accordingly. This allows the owners to conduct tax planning regarding the source and composition of their total income from the business.

Salary Income and Net Corporate Distributions

A shareholder/employee would receive his compensation in salary or wages out of the company's revenue. Then, per the equity split, he would also receive his share of the net profits he is entitled to as an owner of the company after business expenses (including his wages) have been paid. This is important because it distinguishes his ongoing contributions as a worker from the net return on investment. So if the owners plan to sell the business in the future, the potential buyer can more easily project net income from the business after hiring replacement employees for the outgoing owners.

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S Corporation Passive Income Restrictions

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Tax Consequences of Converting a C-Corp to an S-Corp

Corporations are business entities formed under state law that exist separately from their owners. An S corporation is simply a C corporation that has elected to be taxed as a pass through entity. Converting from a C-corp to an S-corp has significant tax implications, which include potentially lowering the overall tax burden on the shareholders, but also changing who reports the income each year and limiting when the income can be reported on the shareholder's tax returns. However, an S-corp must meet several criteria, including having less than 100 owners, only having U.S. resident or U.S. citizen individuals and certain entities as shareholders, and not having more than one class of stock.

Accounting for an S Corporation Shareholder Buyout

An S Corporation is a small business that generally protects its 100 or fewer shareholders from the business’s liabilities. Unlike most corporations, the business income is divided amongst the shareholder to include on their personal returns. This allows the business to avoid “double taxation.” To obtain this benefit, the business must conform to IRS imposed restrictions that limit who can own shares in the corporation. As a result of these restrictions, many of these businesses have established rules regarding when and how a corporation can buy out a shareholder, which ultimately defines how the corporation accounts for that transaction.

Advantages of LLC vs. an S-Corporation

A limited liability company (LLC) is a form of business organization authorized by state statutes to accommodate business needs for limited liability, pass-through taxation and operational flexibility. An S corporation is a corporation that enjoys limited liability, as well as pass-through taxation under Subchapter S of the Internal Revenue Code, as long as it meets certain standards. Each type of entity offers certain advantages.

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