A business may use a variety of methods to compensate persons who provide services to it.
Some of these methods include salaries or wages, personal draw, cash for services, and property for services.
This section discusses the tax consequences of compensation for services provided by the owner of the business.
Compensation to non-owner third parties, including the spouse or children of a sole proprietor, generally will be a deductible expense so long as compensation is reasonable and the services are necessary to the business.
A sole proprietor is not considered an employee of the business and does not receive wages or salary for tax purposes. A sole proprietor is subject to tax on the net income of the business as it is earned, regardless of whether it is withdrawn. Compensation for services or other amounts withdrawn from the business thus are considered withdrawals of income and are not again taxed at the time of withdrawal.
Like sole proprietors, partners of a general partnership are not considered employees of the business and do not receive wages or salary for tax purposes.
The partners are subject to tax on their share of partnership income as it is earned, regardless of whether it is withdrawn.
Amounts withdrawn by a partner for compensation or other purposes are considered withdrawals of income and are not again taxed at the time of withdrawal. However, withdrawals in excess of a partner’s basis are taxed.
Payments to owners: Payments to shareholder-employees in the form of salary or wages are deductible by the corporation in determining taxable income. As with other wages and salaries, these payments are taxed to the recipient as wage or salary income.
Payments must be reasonable and the services must be necessary to the business.
Compensation to shareholder-employees which is found by the Internal Revenue Service to be unreasonable may be reclassified as a dividend. This is to prevent using salary payments as a device to avoid double taxation of corporate profits.
Payments to owners: The payment of wages or salary to S corporation employees, including owner-employees, is deductible by the corporation in determining taxable income.
These payments are then taxed to the recipient as wage or salary income. Payments must be reasonable and the services must be necessary to the business.
The question of unreasonably large salaries to shareholder-employees of S corporations is not as important as it is in C corporations, because the S corporation generally pays no taxes at corporate rates. However, the Internal Revenue Service may challenge salaries which are used as a device to shift income to shareholders in lower income tax brackets.
Note: Special rules apply to tax treatment of property, such as stock, received for services.
Business owners contemplating such transfers should consult with their tax advisor prior to the transfer.
CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Twenty-eighth Edition, January 2010, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.
This is also part of a series of articles on How to Pick the Right Business Entity Type. These articles help you select the right business type for your circumstances.