Embarking on the path of entrepreneurship is a voyage filled with boundless possibilities, numerous decisions, and, yes, some challenges too. One pivotal decision lies in determining the best way to pay yourself for the sweat, time, and talent you pour into your dream venture. This decision hinges on the legal structure of your enterprise. In this blog, we address compensation and distributions for the most common legal business entity structures chosen by small business owners, which include sole proprietorship, partnership, single-member limited liability company (LLC), Subchapter S corporation (S corp), and Subchapter C corporation (C corp).
Let's delve into these structures, using real-life examples to illustrate the intricacies of compensation and distributions and their respective tax consequences.
Sole Proprietorship
Imagine a craftswoman, Sarah, who makes exquisite handmade jewelry. She sells her creations online, operating as a sole proprietor. In this structure, Sarah doesn't draw a traditional salary. Instead, she takes home the profit as her personal income, which is subject to self-employment taxes (Medicare and Social Security) along with income taxes.
Partnership
Take the case of David and Lisa, who run a thriving boutique bakery. As partners, they can choose to take distributions from the bakery's profits. Lisa, an early riser, also bakes the goods, so she receives "guaranteed payments," much like a salary for her additional services. These payments are deducted from the bakery's income and are subject to self-employment taxes. The distributions they take are generally not subject to these taxes but are part of their share of the partnership's profits after tax.
Single-Member Limited Liability Company (LLC)
Consider Jack, a savvy tech consultant who established his single-member LLC. As an LLC, Jack can choose to be taxed as a sole proprietorship or a corporation. Typically, he pulls money from the LLC as draws, similar to Sarah. As noted above, the single member takes home the profit as personal income, which is subject to self-employment taxes when treated as a sole proprietorship. If Jack opts for his LLC to be taxed as a corporation, he could pay himself a "reasonable" salary subject to employment taxes, then take additional profits as dividends, taxed at a potentially lower rate.
Subchapter S Corporation (S Corp)
Emma runs a successful marketing agency and has chosen the S corp structure. As an S corp owner, she is considered an employee and is required to pay herself a "reasonable" salary before taking additional profits as distributions. Her salary is subject to employment taxes, but the distributions are generally only subject to income tax, providing a more tax-efficient method of receiving her earnings.
Subchapter C Corporation (C Corp)
Finally, meet Max, who owns a bustling tech startup, a C corp. Max draws a salary, which is an expense to the corporation and subject to employment taxes. Beyond this, he can also receive dividends from profits. These dividends, however, are subject to double taxation - once at the corporate level and again at the individual level when Max receives them.
Compensation vs. Distributions: Decoding the Difference
Compensation refers to the salary or wages you receive for the work done in your business. It's subject to employment taxes (Medicare, Social Security) and income taxes. Distributions in the form of dividends generally receive preferential tax treatment at lower tax rates. Distributions unrelated to dividends are generally not subject to taxes; instead, they reduce your tax basis, which impacts the amount of gain or loss you will need to recognize when you sell your share of ownership in the business.
In terms of taxes, compensation is taxed at your personal income tax rate and is subject to employment taxes. Dividend distributions, conversely, are taxed at preferential capital tax rates and are not subject to employment taxes. Distributions received that exceed your tax basis in the business may be subjected to taxes at the preferential capital tax rates.
Strategic Considerations
If you're operating an S Corp, LLC taxed as a corporation or a C Corp, it's essential to strike a balance between salary and dividends. For instance, if Emma from our S Corp example pays herself an excessively low salary while taking high distributions, it might be viewed as an attempt to evade payroll taxes, inviting unwanted scrutiny from the IRS. Similarly, Max's tech startup needs to balance salary and dividends, considering the double taxation on dividends in a C Corp.
Also, while distributions may save on employment taxes, they do not count toward retirement contributions. So, if you plan to contribute to a retirement plan based on earned income like a SEP-IRA or a Solo 401(k), you'll want to ensure you take enough salary to support your contributions.
The Bottom Line
Entrepreneurship is an exhilarating voyage; every journey is as unique as the entrepreneur undertaking it. Each legal entity structure has its strengths and weaknesses concerning owner compensation. While a sole proprietorship or partnership allows for more straightforward income draws, an LLC, S Corp, or C Corp might offer more tax efficiency by balancing salary and dividends.
Nevertheless, always consult a trusted tax advisor or accountant to navigate these complexities. After all, building a successful business isn't just about making money - it's also about strategic planning to make your money work best for you.