Another fabulous question came my way today from a small business owner that is actually proving to be monetarily successful and wants to know how to pay herself while minimizing her tax burden. Basically the answer depends first on the type of business structure elected, sole proprietorship, partnership, corporation, S-corporation, or LLC. The following is some text and links pulled off the IRS web site to help answer the question…
An officer of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee. Refer to “Who Are Employees?” in Publication 15-A, Employer’s Supplemental Tax Guide (PDF).
Partners are not employees and should not be issued a Form W-2 in lieu of Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership. Refer to partnerships for more information.
Any distribution to shareholders from earnings and profits is generally a dividend. However, a distribution is not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in money, but they may also be in stock or other property. For information on shareholder reporting of dividends and other distributions, refer to Publication 550, Investment Income and Expenses.
Form 1099-MISC or Form W-2 wages
You cannot designate a worker, including yourself, as an employee or independent contractor solely by the issuance of Form W-2 or Form 1099-MISC. It does not matter whether the person works full time or part time. You use Form 1099-MISC, Miscellaneous Income (PDF) to report payments to others who are not your employees. You use Form W-2 to report wages, car allowance, and other compensation for employees.
Treating employees as non-employees
You will be liable for social security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a non-employee, including yourself if you are a corporate officer, and you may be liable for a trust fund recovery penalty. Refer to Publication 15, Circular E, Employer’s Tax Guide for details about the trust fund recovery penalty or Independent Contractor for more information on employee classification.
Shareholder loan or officer’s compensation?
A loan by a corporation to a corporate officer should include the characteristics of a loan made at arm’s length. That is, there should be a contract with a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay the loan. Collateral would also be an indication of a loan. A below-market loan is a loan which provides for no interest or interest at a rate below the federal rate that applies. If a corporation issues you, as a shareholder or an employee, a below-market loan, the lender’s payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction. Refer to “Employees’ Pay/Kinds of Pay/Loans or Advances” in Publication 535, Business Expenses for more information.
Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to “Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses for more information. Public libraries may have reference sources that provide averages of compensation paid for various types of services. The Internal Revenue Service may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder if the officer is substantially underpaid for services provided.
If you are a sole proprietor or partner in a partnership, the money or other forms of payment you take from your business should be accounted for in a draw account. This helps you know what amount of benefits you have taken from the business during the year. You cannot deduct the sole proprietor s own salary or any personal withdrawals made from the business.