Sometimes owner-managers, who provide services to the business, own business interests in the same business with owners, who are not managers and do not provide services to the business. The differences in tax treatment for these two categories of owners causes tension between them, which can result in ownership disputes. The tension arises from the way these different types of owners take profit from the business, especially if the business is incorporated.
Partnerships and limited liability companies have profits or losses treated as having been distributed whether distribution of such amounts actually is made. Owners are taxed on profits and may deduct losses from other income to the extent of their basis (generally paid-in capital) in the business. Owner-managers do not receive wages or compensation for services rendered to the business entity, are taxed on profits, and may deduct losses from other income to the extent of their basis. Owner-managers are required to pay a 15.3% self-employment tax consisting of Social Security and Medicare taxes on profits distributed. Owners are not liable for the self-employment tax.
C corporations (corporations not electing S corporation tax treatment) are taxed on income and are allowed deductions for salaries and wage compensation but not dividends. S corporations are generally exempt from federal income tax (other than on certain capital gains and passive income) and pass-through profit (or net losses to the extent of basis) to shareholders. The S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of income or loss on their individual tax return. Thus, the business profits are taxed at individual tax rates. S corporation owners can use the business's losses (such as those incurred during startup) on their personal returns as deductions to the extent of paid-in capital. The pass-through nature of the income means that the corporation's profits are only taxed once - at the shareholder level. S corporations therefore avoid the so-called "double taxation" of dividends that occurs with C corporations where income is taxed to the business and if paid to the owner as a dividend also is taxed to the owner. S corporations, like C corporations, can decide to retain their net profits as operating capital; however, unlike a C corporation, all profits are considered as if they were distributed to shareholders. Thus an S corporation shareholder might be taxed on income not distributed (actually paid) to the shareholder. Owner-managers active in the business may be able to benefit from funds retained in the business, while owners, not active in the business, will be taxed on undistributed profits. A shareholder of a C corporation is taxed on dividends only when those dividends are actually paid to the shareholder.
The Internal Revenue Code allows a corporation to deduct from its taxable income a reasonable allowance for salaries or other compensation for personal services actually rendered or for payments purely for services. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation's taxable income. So by treating payments of profit to an owner-manager as salary (instead of a dividend), a C corporation can reduce its income tax liability without greatly increasing the income tax of the recipient. Dividends are taxed at a lower maximum rate than salaries (15% for dividends and 35% for salaries) so the allocation may be adjusted for maximum benefit for the corporation and the shareholder. S corporations can save their owner-managers self-employment or Social Security and Medicare taxes by allocating profit amounts between wage compensation and dividend payments (the self-employment tax is paid only on the share allocated to wage compensation). Occasionally the Internal Revenue Service challenges the allocation of a corporate salary on the ground that it is not a reasonable allowance for salaries or other compensation for personal services actually rendered.
Generally, with owner-managers, an S corporation is motivated to pay as small a salary as might be deemed reasonable (reducing the self-employment tax to be paid by an owner-manager), while a C corporation is motivated to pay as large a salary as might be deemed reasonable (to increase the wage deduction against corporate income). An owner who is not a manager does not have the option of receiving funds from C corporation profit as wage compensation. An owner who is not a manager will be deemed to have received profit distributions from an S corporation when the funds were not paid. The decisions made governing payment of salaries and wage compensation and the amount of dividend payments will affect the net amount realized after tax differently based on whether the shareholder is an owner or an owner-manager.
On an after-tax basis, it is difficult to accomplish equivalent payments of profit to owner-managers and owners. Because these decisions are complex, unequal tax treatment may occur even though it is unintentional. The tension created between the parties will increase in proportion to the inequality. The best way to prevent this problem is to organize ownership so that there are classes of ownership and each class is treated appropriately with respect to the other classes. For instance, having two classes of stock in a C corporation would allow two different rates of dividend payments to be made to an owner-manager class and an owner class. While an S corporation cannot have two classes of stock, ownership percentages might be adjusted to accomplish equality in net payments of profit from the S corporation. If necessary, voting and nonvoting classes can be used (even with the S corporation if voting is the only difference between classes) so that control issues are alleviated. Organizing entities so that the net distribution from the business is accomplished in a fair and equitable matter removes a source of tension and prevents disputes between owners and owner-managers.
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