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How is an owner of a business “compensated”?
The owners of a corporation may be compensated in two primary manners. The acceptable method of compensation depends upon the type of business entity and the role that the owner plays in the business. Some business entities allow business profits to pass through the business directly to its owners. These owners receive either a percentage of the profits based upon their ownership percentage or a percentage based upon a special allocation of business profits that differs from their ownership percentage. Other business entities (specifically corporations) compensate owners by distributing dividends from business profits. Unlike flow-through profits, payment of dividends is generally a decision by the board of directors and does not represent all profits of the corporation. That is, the corporation determines the amount of any dividends paid to shareholders and may retain any percentage of profits within the corporation.
- Note: A corporate employee who is also a business owner must receive a reasonable salary for her services to the corporation. Otherwise, a portion of any share of corporate profits distributed as dividends will be treated as salary. This makes a difference in how the funds are taxed to the individual. An owner of any other type of business entity does not receive a salary and is compensated by receiving a distribution of profits.
- Example: I am a shareholder and CEO of ABC Corp. I will receive a salary for my services as as CEO, and I will receive a dividend if any are paid to shareholders. Corporate business entities (or business entities taxed as corporations) require that an owner who also serves as an employee of the business to draw a salary from the business. The salary is separate from any distribution of dividends.
Discussion: Is it common for owners of a business to also serve as employees of the business? Are most owners of a business in the US employees of the business? Please explain.
Practice Question: Frank and Judy are members of an LLC. Both Frank and Judy work in the LLC and each is a 50% owner. What other information do we need to know to determine how Frank and Judy are compensated?
- An LLC may be taxed as a partnership or corporation. This election will determine the possibility for compensating owners who work in the business. In a partnership-taxed LLC, members cannot receive a salary. They must be compensated as a “draw” from company funds. If the entity is taxed a corporation, the members who work in the business must be compensated as employees. They can also be compensated with distributions of company profits or retained equity. To determine how Frank and Judy are compensated, you would need to know the tax election and whether each of them work in the business.