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Tax Tip: Compensation for Business Owners

Posted: Oct. 1, 2012, 2:45 p.m. EDT


By Mark E. Battersby

The Internal Revenue Service is reportedly scrutinizing the tax returns of businesses operating as S corporations where the owner’s or officer’s compensation is too low—all because the government is losing out on Federal Insurance Contributions Act (FICA) taxes and other payroll taxes. This brings up the question: Are you an employee of your pet products business?

More importantly, at least to our lawmakers and the IRS, does your business compensate you for services provided to the business? With a sole proprietorship, for example, all income from the business goes into the owner’s pocket, while expenses are paid from those pockets and anything left is labeled as profits and taxed. Although a sole proprietor is often legitimately called an “employee” of the business, in reality, the owner is the business.

Businss profits
When a second or separate business entity enters the picture, things become confused for tax purposes. Questions about salaries paid to the owner/employee and whether payroll taxes have been—or should have been—withheld, are raised. Should those distributions have been more accurately labeled as dividend payments? Also, will the retail operation be penalized if it keeps profit in the business rather than paying them to the owner/employee in the form of either wages or dividends?

Generally, every owner who is also an employee of a profitable pet business should receive amounts labeled as both wages and dividends. The business can reward the owner and employees with both bonuses and fringe benefits, although favoring the owner at the expense of others within the business is a definite “no-no” in the eyes of the IRS.

Owners who are also employees must include some but not all of the amounts received from the business in their taxable income, although the tax rate usually varies depending on the type of payment. The business can generally claim a tax deduction for some, but not all, of those amounts distributed or paid to owners as wages or salaries. Dividends paid by the business to shareholders are not tax deductible by the business.

Confused? It’s not surprising given the complexity of the U.S. federal tax laws, and all the tax breaks, limits and penalties that are such an integral part of the system. The type of entity under which the business operates (sole proprietorship, partnership, corporation, S corporation, limited liability corporation, limited liability partnership or personal services corporation) contributes significantly to the confusion in this area. So, too, do questions such as whether profits from the business are dividends or wages, whether too much compensation was paid to a shareholder or employee, or whether excessive profits were retained in the business, which draw fines and penalties when discovered.

Are you an employee of your business? What might have at first seemed to be a basic question is actually an extremely complex one to answer. It is also a question without a definitive answer. There is, however, no excuse for not seeking professional guidance in reaping those tax breaks due to you.

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