Compensation in General

When advising clients regarding compensation, we must first look to the type of entity structure.

Partnerships and LLC Members – Sub K Part I

Owners in pass through entities (taxed under IRC Subchapter K) cannot receive a “salary” per se. (Remember they are not employees.) There are technically two types of payments that are made to owners in Sub K taxed entities: distributions and guaranteed payments. Sub K entities can distribute money from earnings to their partners/members in the form of distributions. Usually, the Partnership or Operating Agreement sets forth how, and when distributions are made. Distributions impact basis and equity accounts. The tax ramifications that go along with distributions are too detailed for analysis here.

The other way that Sub K entity owners can receive money from the entity is through “guaranteed payments.” From the name, such payments may sound like salary payments. However, they are not, because remember, Sub K entity owners are not employees so they cannot receive a salary. This is not to say that guaranteed payments don’t resemble a salary to the owners. They very much can have salary-like attributes: regular pay, a distinct amount, etc.

📖 Read IRC and , you can view Section 707 in its entirety here.

As you can see, guaranteed payments are made even if the entity is losing money. If they are contingent upon the entity making money, then they are not guaranteed payments and will be treated differently.

Similar to salary, guaranteed payments are deductible by the entity (§ 162 – ordinary and necessary business expense), or sometimes capitalized under § 263.  The payments will be taxed as ordinary income to the owner who receives them. Unlike salary, the entity does not withhold taxes on these payments because a partner or LLC member is not an “employee” for withholding purposes.

Also of note is that Sub K entity owners are not considered employees for purposes of a variety of other benefits such as healthcare, tax-qualified deferred compensation plans (401(k) and cafeteria plans), and fringe benefits. As such, all benefits paid for a Sub K entity owner are taxable as ordinary income to that owner. Look back at § 707(c). When Sub K entities pay for their owners’ benefits, such benefits are considered “guaranteed payments.” Can you see why? They are made “without regard to the income of the [entity].” Think about these benefits and how many of them are tax-free to employees but they are not tax-free to Sub K entity owners.

There may be a temptation to treat such owners as employees but that will have serious consequences. For example, if you include such owners in IRC § 125 tax-qualified cafeteria plans or 401(k) plans, you may disqualify the plan entirely. If you’d like to know how to work around some of these tax issues, read Noel P. Brock, “Treating Partners as Employees: Risks to Consider” (Aug. 1, 2014).

As shown below there are numerous ways that shareholders and executives in a C-Corp can be compensated. It is possible to rework some of the below compensation methods for Sub K entity execs. See “Partnerships and LLC Members – Sub K Part II.

C-Corporations

Recall that corporations issue stock to indicate ownership. As such, a corporation’s owners are called “stockholders” or “shareholders.” This section will discuss compensating founders or shareholders of corporations that also provide services to the business.

Corporations can issue dividends to its shareholders. Such dividends are based on the number of shares that the shareholder owns. For instance, if the company is giving a dividend equal to $1/share, then a shareholder who owns 20 shares will receive $20 no matter how much work they are doing for the company. Dividends are not tax deductible by the corporation and are taxed as dividend income to the shareholder. (You may remember from Unit 8 “Tax Considerations” that this is the double taxation effect.)

Because dividends are not akin to a fair wage for work, shareholders who are employed by the company need to be compensated in other ways. Shareholders who are employed by the company are employees. As such, they are permitted to receive tax free benefits like other employees.

Employees (including employee-shareholders) can be compensated in a variety of ways such as salary, bonuses, and equity based compensation. There is no shortage of creative ways to compensate employees nowadays. This section will discuss various ways that can apply to all employees, but remember that typically it is the employee-shareholders that are seeking the bigger compensation. Similarly, executives are compensated well and many of the types of compensation discussed below will also apply to them.

Some methods of compensation are not only meant to compensate the individual but also to incentivize them. Some methods are cash based and some are equity based.

The following compensation methods will be covered but understand that this is not an exhaustive list: salary, bonuses, incentive compensation, equity compensation.

 

Salary

Employee-shareholders will need regular compensation in which to live. As such, most will receive a salary that is payable with the employee payroll (weekly or bi-weekly). Employee-shareholders are part of the payroll system just like other employees and therefore will have tax withholding and receive a W-2. Their salary is tax-deductible to the company and it is ordinary income to them.

 

Bonuses

Bonuses are another popular way to compensate employee-shareholders. Bonuses can be guaranteed or contingent upon an occurrence (incentivizing). Regardless of whether they are guaranteed or incentivizing, they can be cash or equity based. Guaranteed bonuses do not incentivize an employee because they are guaranteed regardless of the employee’s or company’s performance. Still guaranteed bonuses can serve a purpose. Take for example a sign-on bonus. A sign-on bonus is given to someone in a lump sum payment for coming on board – it does nothing to incentivize a person to stay or perform well.

Most bonuses are used to incentivize or handcuff someone. Incentivizing someone to do well or contribute to the company’s overall success is an important feature of compensation. Handcuffing is a term used when a company incentivizes someone to stay for a certain period of time. For instance, if a company hires a new CEO and it wants them to stay on for at least 5 years, it may provide a bonus that will not be given until year 5. If the CEO wants said bonus, they have to stick around for the 5 years. More ways to handcuff and incentivize will be covered in the next section.

Other bonuses reward employees for on-the-spot achievements, so called “achievement awards.” Referral bonuses are also pretty typical depending on the business. Referral bonuses can come from another employee referral or a customer referral. I once worked for a firm that gave me 25% of the billings of any new client I brought into the firm. This was incentivizing and could be quite lucrative! There are smaller bonuses as well such as holiday bonuses.

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To the extent possible under law, Samantha Prince has waived all copyright and related or neighboring rights to Entrepreneurship Law: Company Creation, except where otherwise noted.