How Do Owners Of An LLC Or S Corporation Get Paid?
When taking money out of a business, transactions must be carefully structured to avoid unwanted tax consequences or damage to the business entity. If the loan and repayments are not set up and processed properly, the IRS can reclassify the funding as nondeductible capital contributions and classify the repayments as taxable dividends, resulting in unexpected taxation. A weak loan structure can also create a danger zone where a court can “pierce the corporate veil,” resulting in personal liability for the business owner.
One of the most dangerous financial mistakes a business owner can make is to intermingle funds, such as paying personal expenses from the business checking account, or paying business expenses from the owner’s personal account. This behavior can leave openings for the IRS or courts to question the integrity of the business entity. Failure to maintain complete financial separation between a business and its owners is one of the major causes of tax and legal trouble for small businesses.
A sole proprietor is taxed on self-employment income without regard for activity in the business bank account. A sole proprietor should never pay himself or herself wages, dividends, or other distributions. A sole proprietor may take money out of the business bank account with no tax ramifications.
Taking Money Out – Wages
One way for a business owner to take money out of a corporation is through wages for services performed. Wages are appropriate only for C corporations and S corporations, not for sole proprietorships or partnerships.
Both C corporations and S corporations are required by law to pay “reasonable wages,” which approximate wages that would be paid for similar levels of services in unrelated companies. In a C corporation, wages are deductible by the corporation but dividends are not, creating incentive for a C corporation shareholder to inflate the wages for higher deductions. In an S corporation, wages are subject to payroll taxes but flow-through income is not, creating an incentive for artificially low wages.
Guaranteed payments to partners are the partnership counterpart to corporate wages. With guaranteed payments, there is no withholding for payroll taxes or income tax. These amounts are computed and paid on the partner’s individual Form 1040.
Dividends are generally the means by which a C corporation distributes profits to shareholders. Amounts up to the C corporation’s “earnings and profits” are taxable to the shareholder.
Flow-Through Income—S Corporations and Partnerships
Income from S corporations and partnerships flow through to the shareholder or partner’s individual tax return. Distributions of cash to an S corporation shareholder or partner are not taxable to the individual until the person’s cost basis reaches zero.
A corporation or partnership can receive loans from shareholders or partners, and can give loans to shareholders or partners. There is generally no taxable event when a corporation or partnership repays a loan from a business owner, and no taxable event when a corporation or partnership makes a bona-fide loan to a shareholder or partner.
Limited Liability Companies (LLCs)
A single-member LLC owned by an individual is considered a “disregarded entity” and is taxed as a sole proprietorship by default. If the LLC makes an election to be taxed as a corporation, either C corporation or the S corporation rules apply. An LLC owned by more than one individual is taxed as a partnership by default. As with a single-owner LLC, a multiple-owner LLC may make an election to be taxed as a corporation.
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