By Mark Battersby –
Are you an employee of your rural building business? More importantly, at least to our lawmakers and the Internal Revenue Service, does your business properly compensate you the owner/employee for the services that you provide to the business?
A number of factors contribute to the confusion that this simple question often triggers. With a sole proprietorship, all income from the building business goes into the owner’s pocket while expenses are paid from those pockets with anything left labeled as profits and taxes paid. Although a sole proprietor is often legitimately called an “employee” of the business, in reality the owner is the business.
When a separate business entity enters the picture, questions arise about salaries paid to the owner/employee; whether payroll taxes have been – or should have been – withheld; should those distributions have been more accurately labeled as dividend payments; or will the business be penalized if it keeps profits within the business rather than paying them to the owner/employee as wages or dividends?
Generally, every owner/employee of a profitable building business should receive amounts labeled as both wages and dividends. The business can reward owner/employees with both bonuses and fringe benefits, although favoring the owner/employee at the expense of others within the business is a definite ‘no-no,’ in the eyes of the IRS.
While dividends paid by a building business are not deductible by the business, a tax deduction can usually be claimed for some but, again, not all of those amounts distributed and/or paid to owner/employees as wages or salaries.
The type of entity under which the business operates – sole proprietorship, partnership, corporation, S corporation, limited liability corporation (LLC), limited liability partnership (LLP) or personal services corporation (PSC) – contributes significantly to the confusion in this area. So, too, do questions such as whether profits are considered dividends or wages, whether too much compensation was paid to a shareholder/employee or excessive profits retained in the business, both of which draw fines and penalties when discovered.
Even the increasingly rare sole proprietorship poses potential pitfalls for the unwary owner/employee. Under our tax rules, the term “employee,” unless otherwise indicated, specifically includes owner/employees who participate in an unincorporated enterprise as either a partner or a sole proprietor. When reference is made to the “employer,” a sole proprietor is treated as his or her own employer, while a partnership is considered as the employer of each partner.
An S corporation is simply an incorporated building business that has chosen to be treated as a pass-through entity. In general, an S corporation does not pay income tax. Instead, the corporation’s income and deductions are passed-through to shareholders much like a partnership. The shareholders report the income and deductions on their own income tax returns.
The tax treatment of fringe benefits paid to employees of an S corporation is different from owner-employees who are not shareholders, or who own two percent or less of the outstanding S corporation stock. The fringe benefits paid non-shareholder employees are tax-free. They are excluded from the employee’s taxable wages. Those non-shareholder fringe benefits are deductible by the corporation.
Employee/owners owning more than two-percent of the S corporation stock on the other hand, are not considered employees for fringe benefit purposes, and their fringe benefits may not be tax-free. More-than-two percent owners are treated in the same manner as partners in a partnership.
Profits from closely-held building businesses can be distributed as either wages or as dividends. Double-taxation, once at the corporate level and again at the shareholder level is a problem for many owner/employees. Typically, a closely-held, incorporated building business avoids double-taxation either by paying most of its profits in the form of a bonus, or by leaving profits in the business as accumulated earnings.
The IRS and the courts frequently scrutinize year-end bonuses often re-characterizing the bonus as a disguised dividend. That’s right, with the reduced tax rates on dividends, the focus today is on closely-held, incorporated building businesses that have traditionally paid a large bonus and no dividend but have now switched to the payment of a large dividend and no bonus since the dividend rates were reduced.
The non-payment of sufficient dividends relative to profits can subject incorporated businesses to the accumulated earnings tax – a penalty for retaining already-taxed profits in the business rather than distributing them as dividends.
Each year, the IRS reminds S corporations that they must pay reasonable compensation (subject to employment taxes) to shareholder/employees in return for the services that a shareholder/employee provides to the incorporated business before a non-wage distribution may be made.
In the case of compensation, bonuses and other distributions made to S corporation/shareholders, a major question is often: What amount is “reasonable” for that particular shareholder/employee? And, of course, whether the amount paid for the services provided constitutes “reasonable compensation.”
Although shareholders of a so-called “S” corporation are treated much in the same manner as partners, they are not subject to the self-employment tax on their share of the S corporation’s ordinary income attributable to the operation of the business. After all, a corporation is a separate entity for tax purposes.
Sole proprietors as well as many partners are subject to a so-called “self-employment” tax which is the social security tax, both the employee’s and the employer’s share, of 12.4 percent and a the Medicare tax of 2.9 percent. The tax is based on self-employment income defined as “net earnings from self-employment.”
Spouses who jointly own and operate a building business and share in the profits and losses are considered partners in a partnership, regardless of whether there is a formal partnership agreement. The partnership is considered the employer of any employees, and is liable for any employment taxes due on wages paid to its employees.
Note: If a spouse is an employee, not a partner, social security and Medicare taxes must be paid for him or her.
The wages for the services of an individual who works for his or her spouse in a trade or business are subject to income tax withholding and social security and Medicare taxes – but not to FUTA tax.
Although payments for the services of a child under the age of 18 who works for his or her parent in a building business are generally subject to income tax withholding, they are not subject to social security and Medicare taxes if the parents’ operation is a sole proprietorship or a partnership. Payments for the services of a child under age 21 who works for his or her parent are not subject to federal unemployment (FUTA) tax.
Over the age of 18, the services of a child or spouse are generally subject to income tax withholding as well as social security, Medicare and FUTA taxes.
Finally, in order to both profit from and avoid the potential pitfalls, planning early and often as things change or the building business grows is essential. There is, however, no excuse for not seeking professional guidance in reaping those tax breaks due you, the owner/employee of your building business. Professional assistance can also ensure that you don’t run afoul of the tax laws in this area. RB
Mark Battersby is an expert in tax and financial matters. With more than 30 years experience in small business issues, he lectures and writes extensively on business topics. Contact him at 610-789-2480 or MEBatt12@Earthlink.net.