Owners of companies want a return on their investment. This can take many forms depending on the entity structure.
Dividends can be distributed to shareholders in C-Corporations, as noted above. However, dividends are distributed based on share ownership. For instance, a company may pay a dividend equal to $1 per share. If you have 20 shares, you will receive $20. This works out well for those shareholders who are investors, but this is not the best way to compensate shareholders who work for the C-Corp.
Dividends are not deductible to the C-Corp. However, money used to pay shareholders who work for the company as employees is deductible. This is important. Another benefit is that those who truly work for the company will be compensated based on their work, not based on how many shares they have – as is the case with dividends. The double tax effect does not come into play when you are able to legitimately compensate shareholders as employees thanks to that deduction.
Sidenote: When any individual receives wages, they must remit employment taxes: social security, medicare and Federal Unemployment (FUTA) Tax. (They must pay their half of the employment taxes – the company pays the other half.) When a person receives dividend income, they do not have to remit employment taxes. The tax aspects of this are more complicated than it makes sense to cover here for our purposes, but you’ve been provided with enough information to recognize issues.
What about the pass through entities?
Remember that profits and losses pass through to the owners and that the net income will be taxed at their personal tax rates on their Form 1040. What happens when owners work for the company?
Partners and LLC members often work for the company. The Partnership Agreement or Operating Agreement often sets forth a distribution schedule outlining how and when money comes out to the owners. Regardless of whether or not they receive a distribution, the owners must include in their income their entire share of the profits. Additionally, and here is the sucker punch, not only must one pay income tax on their share of the profits, but one must also pay employment taxes on that same amount. The company does not pay half of the employment taxes, the individual pays the entire amount but then gets to deduct half. As you can see, when a company is successful and the profits are high, owners having to pay the employment taxes can be harsh.
Even though S-Corps are also pass through entities, they are permitted to pay their employee-shareholders wages. Paying them wages eliminates the employment tax problem noted above with the other pass through entities. However, S-Corps must pay their owner-shareholders “reasonable” salaries. It is important that shareholder employees receive reasonable compensation because if it is not what the IRS considers “reasonable” for the industry and job being done, the IRS can reclassify the income. Remember that the company can deduct the wages.
The rest of the money (share of the profits) will not be subject to employment taxes.
Here is an interesting IRS sheet: S Corporation Employees, Shareholders and Corporate Officers.
💡 How do you think the above information can impact the choice of entity?
Please look to Unit 13 for more coverage of founders compensation.