How Do Business Owners Get Paid - Part 2

Limited Liability Companies taxed as Partnerships & S-Corps and Corporations (S-Corp, C-Corp)

Limited Liability Company taxed as Partnership

A limited liability company (LLC) with two or more members is defaultly treated as a Partnership for tax purposes.

With a Partnership, members can receive payments in two ways – Guaranteed Payments and Distributions. Guaranteed Payments are compensation to members for their active services in the business while distributions are made against a member’s capital account. A member’s capital account balance typically includes the member’s initial capital contribution plus their proportionate share of profit/loss from the business. Distributions are made subject to the provisions of the LLC Operating Agreement.

Guaranteed Payments are not subject to tax withholdings so each member may need to make estimated tax payments for self-employment and income taxes to the IRS, state, and local tax agencies on a quarterly basis.

Distributions may be subject to self-employment taxes depending on whether the member has an active or passive role in the business.

Members are responsible for tax liabilities on their proportionate share of profit/loss from the business as reported on their Schedule K-1 regardless of whether they receive a distribution.

Limited Liability Company taxed as S-Corp and Corporations taxed as S-Corps

A limited liability company (LLC) may elect to be treated differently than their default tax treatment by making an Entity Classification Election change with the IRS. Some small business LLCs may elect to be taxed as a subchapter S (S-Corp) in lieu of being treated as a single-member LLC or Partnership for more favorable tax treatment. Likewise, small business corporations may elect to be treated as a sub-chapter S (S-Corp) in lieu of default C-Corp treatment to avoid double taxation. Consult with a CPA or tax professional before making a change.

Shareholders of LLCs and Corporations treated as S-Corps for tax purposes receive payments in two ways – Reasonable Salary and Distributions. Salaries are subject to normal payroll tax withholdings while distributions are generally not taxable provided the shareholder’s distribution does not exceed their basis. Distributions are made subject to the provisions of the Shareholder Agreement.

Shareholders are responsible for tax liabilities on their proportionate share of profit/loss from the business as reported on their Schedule K-1 regardless of whether they receive a distribution.

While the IRS doesn’t go into detail as to what constitutes a reasonable salary, a reasonable salary should align with what others would make in the same/similar role within the same/similar business/industry of the same size and revenue range. The purpose of the reasonable salary requirement for shareholders of LLCs and Corporations electing S-Corp treatment is to prevent shareholders from taking an excessively low salary in favor of higher distributions to avoid certain tax liabilities.

Limited Liability Company taxed as C-Corp and Corporations with default tax treatment

Most small businesses will avoid electing corporation (C-Corp) tax treatment to avoid double taxation at both the shareholder and corporation level (not to mention the reporting/compliance requirements); however, for mid to large size businesses, a C-Corp may be the only option.

Shareholders of C-Corps receive payments in two ways – Reasonable Salary and Dividends. Salaries are subject to normal payroll tax withholdings while dividends are subject to taxation at both the corporation and shareholder level.

While the IRS doesn’t go into detail as to what constitutes a reasonable salary, a reasonable salary should align with what others would make in the same/similar role within the same/similar business/industry of the same size and revenue range. The purpose of the reasonable salary requirement for shareholders of C-Corps is to prevent shareholders from taking an excessively high salary in lieu of greater dividends to avoid certain tax liabilities.

This is intended as a general overview so be sure to consult with a CPA or tax professional for questions related to your specific business and tax situation.