Business owners are able to also work in their business as employees. This means they can earn wages or base salary, as well as their share of net profit from the business. An S corporation is a special type of business entity that has a favorable tax treatment by the Internal Revenue Service. As part of its pass-through tax status, it is required to treat all of its owners equally. However, there is no requirement that its owners work as paid employees for the S corporation in equal amounts or for equal compensation, or at all.
S Corporation Election
By default, an S corporation starts out as a regular C corporation. After the company is formed, its shareholders may make a unanimous election with the IRS to be taxed as a disregarded entity. This is often done in small businesses that wish to avoid double taxation of the profit from the business. Nonetheless, it still is a legal corporation that is subject to the corporation statutes of the state in which it was initially formed.
Shareholders of an S corporation are entitled to share in the company's profits and losses in proportion to the equity split or relative ownership interest. As with a partnership, income taxes are not paid at the entity level, but instead are paid by the individual owners via their personal income taxes. Thus, for most practical purposes, small S corporations behave very much like general partnerships.
Shareholders as Base Salary Employees
An S corporation is an independent business entity and shareholders can work for the company as paid employees. Any compensation, such as base salary or wages, paid to a shareholder of an S corporation who works for the company as an employee is considered a business expense and comes out of the company's gross income accordingly. This allows the owners to conduct tax planning regarding the source and composition of their total income from the business.
Salary Income and Net Corporate Distributions
A shareholder/employee would receive his compensation in salary or wages out of the company's revenue. Then, per the equity split, he would also receive his share of the net profits he is entitled to as an owner of the company after business expenses (including his wages) have been paid. This is important because it distinguishes his ongoing contributions as a worker from the net return on investment. So if the owners plan to sell the business in the future, the potential buyer can more easily project net income from the business after hiring replacement employees for the outgoing owners.
Read More: Corporation: Withdrawal Vs. Dissolution
Jeff Clements has been a certified public accountant and business consultant since 2002. He has also worked in private practice as an attorney. Clements founded a multi-strategy hedge fund and has served as its research director and portfolio manager since its inception. He holds a Juris Doctor, as well as a master's degree in accounting.