sole proprietors or partners in a partnership/LLC

If you are a sole proprietor, you don’t take a salary in the form of a regular paycheck as as employee. Amounts taken out of a business by a sole proprietor should be accounted for in a draw account. You cannot deduct the sole proprietor’s own “salary” or any personal withdrawals made from the business.
Partners in a partnership also do not get paid a specific salary. A partner can take distributions or guaranteed payment from the partnership profits and are taxed based on their share of those profits on their partnership income tax return.
Single-member LLC owners are considered like sole proprietors for federal tax purposes, and multiple-member LLC members are considered like partners in a partnership.

Sole proprietors, partners of a partnership and members of an LLC are not employees for both the employment tax purpose and the income tax purpose. They do not take a salary as an employee. No FICA taxes (Social Security/Medicare) are deducted and no federal or state income tax is withheld. They should not be issued a form W-2 or 1099-MISC. Partners should be issued schedule K-1 (1065) for distributions or guaranteed payments from the partnership.

Owners of sole proprietorships, partnerships, and LLCs are self-employed individuals for Self-employment tax (the equivalent of FICA tax) purpose. They must pay self-employment tax when they complete their personal tax return for the year. The amount of self-employment is calculated based on the net profits of the business and is paid to the IRS along with federal income taxes.

Corporate officers

An owner of a corporation or S corporation is a shareholder. The definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code include corporate officers. This does not change by the mere fact that an officer is also a shareholder. Courts have consistently held that corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.

The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.

Wage Compensation for S Corporation Officers

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.  Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes.  Federal tax law says that DISTRIBUTIONS to shareholders that work for the corporation are first treated as salaries paid to the shareholders up to the point that they have been paid a reasonable salary. A distribution includes anything (money, property, relief from debt, whatever) the shareholder gets from the corporation, either directly or indirectly. So, if the corporation has been paying these shareholders anything, that first must come out as wages up to a reasonable salary. That salary is subject to federal employment taxes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

Reasonable compensation

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. Form 1120S, U.S. Income Tax Return for an S Corporation instructions state: “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” The amount of compensation is limited to the amount received directly or indirectly by the shareholder. However, if cash, property or the right to receive either cash or property is received by the shareholder, a salary amount must be determined and the salary level must be “reasonable and appropriate.”

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case. Some factors considered by the courts in determining reasonable compensation include:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

Do you have to pay yourself as wages?

Not really. 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 cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate. However, the amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. If the S-corporation has not paid out anything to the shareholders, then there have been no distributions yet to treat as salary. For example, if the S-corp is losing money and not making distributions, then salary would be uncalled for. In effect, the shareholder would be deferring his or her salary until better times. When the corporation makes a big distribution of earnings in later year, they will have to treat that as wages for all the work done to date for the corporation first. That may push the income into being taxed at a higher rate than it would have been had they paid it out every year. Whether that’s better or worse ultimately depends on a careful analysis of their situation and what they project is likely to occur with the business in the upcoming years.

How often should you pay yourself?

An employee and employer may agree in an annual initial contract of employment to monthly pay periods when the employer shall pay all employees for all labor performed or services rendered. Otherwise, the employer shall establish monthly or semi-monthly pay periods, at the election of the employee.

If an S corp had one shareholder was also the only employee. This owner keeps financial records, controlled corporate bank accounts. He or she may grow tired of the semi-weekly or monthly tax deposits and ask a tax expert to see if there is a leeway for taxes and payroll preparation. If FICA taxes for a quarterly period are less than $2,500, the owner can remit the taxes with the quarterly (Form 941) return in lieu of depositing them. A plan can be designed under which the owner could make regular transfers from the company account to his personal account and record each as a salary advance. At the end of each quarter, the owner would adjust the advances and salary for the each and make a payroll tax deposit for the quarter.

Some owner may push further for one annual paycheck and make one annual payroll tax deposit. The Fact Sheet 2008-25 states that the amount of the [recharacterized] compensation will never exceed the amount actually received by the shareholder, either directly or indirectly. Thus, if no direct or indirect payments are made to the shareholder, there will be nothing for the IRS to recharacterize as salaries. So if the owner does not pay himself advances during the year, he can make a single annual payroll at the end of year.

Form W-2 or Form 1099-MISC

You use Form W-2 to report wages, car allowance, and other compensation for employees, including yourself. It does not matter whether the person works full time or part time. You cannot designate an employee as an independent contractor solely by the issuance of Form 1099-MISC in stead of Form W-2.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.

In a “damage control” context with 1099, some practitioners who have taken over such clients after the fact have resorted to treating a certain amount of the distribution as being nonemployee compensation subject to self-employment tax. Such a resolution is not without its risks-as noted in the beginning, these two taxes are separate from each other, and while we would hope the IRS would take a “no harm, no foul” position on such cases, it’s theoretically possible the IRS could assess the FICA tax against the corporation after the statute had closed on a claim for refund on the self employment tax if the corporation had not filed any payroll tax reports in the year in question.

That fact pattern is often found in one owner S corporations with no other employees who were advised by a “professional” to use the S corporation to avoid FICA or who “did their own research on the Internet” on this matter. In those cases, there’s often significant resistance to file late Form 941s, since they are going to be subject to penalties for late payment of tax and late filing. Practitioners may need to consider their own exposure if they are associated with such a return and, at a minimum, want to be sure they have advised the client of the risks associated with such a position and that they make clear that the client could be subject to penalties and the possibility of paying the same tax twice if they go this route.” Paying SE tax does not mean that the payroll taxes are being paid. That does not excuse the failure to report your compensation as wages. The corporation can be held liable to pay both halves of the payroll taxes plus penalty and interest regardless of the self employment tax that was paid individually. That is, there is no protection at all from the payroll liabilities by issuing a 1099-MISC.