In my practice as a small business coach and mentor, a question I often get asked is how do I get paid as a business owner? What makes this question so hard to answers is that it all depends on the type of entity you are and how many owners there are.
Some entities have only one owner while others may have several owners, which changes the way income tax is reported to the IRS.
In a pass-through entity, sometimes income is considered earned income (sometimes called ordinary income or active income) while other times it is considered passive income, which changes the way income taxes are computed.
Your role in the business as a decision maker (manager/officer) or a simple investor (member/shareholder) will define how your income taxes are calculated.
Income tax treatment, therefore, will dictate the way you will get paid as an owner.
In the next few posts, we will discuss in greater detail how you get paid as an owner of a small business based on various situations. In this post, I want to lay the groundwork and define a few terms that should help demystify how entities pay the owners of the business. Subsequent posts will look at the specifics associated with each entity type and owner situation. Here are a few basic concepts that we must discuss first.
What Is a Pass-Through Entity?
Most small business founders choose one of the many entity types known as pass-through entities. By definition, a pass-through entity is not subject to income taxes at the entity level. Rather, the owners are taxed individually based on their ownership share of the business in a tax-advantaged way. The only entity not considered a pass-through is the C-Corp and we will not discuss C-Corps in the context of this series of posts.
What Are Your Pass-Through Entity Type Options?
Technically, when it comes to an entity selection, there are just four basic types: sole proprietor, limited liability company (LLC), partnership, and corporation. However, each has some variations that are useful in explaining how taxes work and how owners/managers get paid works. Therefore, the following is a list of several common pass-through type entities often used when describing a small business.
Sole Proprietor (SP)*
Single Member Limited Liability Company (SMLLC)**
Multi-Member Limited Liability Company (MMLLC)
General Partnership (GP)*
Limited Partnership (LP)
S-Corp
*A sole proprietor and general partnership are technically not specific entity designations you would make with the Secretary of State. A sole proprietor is simply when one person decides to operate a business while a general partnership is simply when two or more persons decide to operate a business. In both cases, you do not file for a specific entity status with the Secretary of State. Since the business is not separate from the individual(s), there is no type of liability protection. We use the sole proprietor (SP) and general partnership (GP) designation only to distinguish them from other entity types since they are treated differently by the IRS.
**A single member LLC is not a specific entity designation. It is simply an LLC with only one member and therefore is treated differently than an LLC that has more than one member. We use the single member designation (SMLLC) only to distinguish it from a traditional LLC with several members.
How to Report the Profit and Loss of Business
A company should have a Profit & Loss (P&L), or income statement, which is an internally prepared tax document that is used by the business to compute the business owner(s) annual tax liability.
When the business is a SP or a SMLLC, the figures from the P&L are used to populate the owner’s Schedules C (profit and loss from business) and Schedule SE (self-employment tax).
When the business is a MMLLC or LP, the P&L is used to produce Form 1065 . When you are an S-Corp, the P&L is used to produce Form 1120S . Both the 1065 and 1120S are informational tax returns that are sent to the IRS. The business will also produce K1’s that are sent to each owner.
What Is Passive Income vs. Earned Income?
When the income derived by the business comes as the result of some form of labor, then the income is classified as earned income. Earned income is subject to FICA (Social Security) and Medicare taxes.
However, sometimes income from the business does not involve labor, such as when a business’s income comes from charging rent to a tenant. When the income is not the result of labor, the income is considered passive income, and as a result, it is not subject to FICA or Medicare taxes and is reported on Schedule E of the individuals 1040 tax return.
Even within a single entity, the income for one owner may be considered earned income while another owner’s income might be considered passive income. The distinction comes if the individual owner either works more than 500 hours in the business or is in a management position and makes day-to-day decisions for the business.
When an owner’s income is considered earned income, that owner has some options for tax deductions such as healthcare or retirement contributions that owners who receive passive income do not. Of course, the owners with earned income then subject that income to FICA and Medicare taxes.
What Are Self-Employment (SE) Taxes?
As an employee, we are used to having 7.65% deducted from our net income as our part of our FICA and Medicare tax contributions. What you don’t see as an employee is that the employer is obligated to match your FICA and Medicare tax contributions.
When your income from the business is considered earned income (therefore subject to FICA and Medicare taxes) and you are also an owner of the business, then you are both the employee and employer in the eyes of the IRS. As a result, you must pay both the employee and the employer portions of FICA and Medicare taxes. When we talk about self-employment or SE taxes, we are including both the employee (7.65%) and employer (7.65%) portions of the FICA/Medicare contribution for a total of 15.3%.
In subsequent posts, we will look at how you get paid as an owner and/or manager of various entities, including:
Do you know how to get paid as an owner for a pass-through entity?
I would like to acknowledge Karen Absher of KSA Financial & Tax Services for her gracious assistance as a reviewer to make sure that the tax issues conveyed in this post were an accurate representation of US tax law.
