Paying the Boss: What's the Tax Deal?

Most companies are familiar with the basics of payroll rules: the differences between exempt and nonexempt, overtime, withholding tax, and the like. What about owners, partners and corporate directors? Corporate Officers. A corporation officer is generally an employee. However, officers who perform no services or only minor services, and who neither receive nor are entitled to receive any pay, are not considered employees.

Partners. Partners are not employees, even if they're active in the company. They do not get a Form W-2, but rather a Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership.

Dividend Distributions. Any distribution to shareholders from earnings and profits is usually regarded as a dividend. However, it’s not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in money, but they may also be in stock or other property.

Shareholder Loan vs. Officer's Compensation. A loan a business makes to a corporate officer should include the characteristics of the loan made at arm's length —if the firm wants it treated as a true loan. There should be a contract with a stated interest rate, a specified duration of time for reimbursement and a consequence for failure to repay. There may be collateral as well. A below-market loan provides for no interest or interest at a rate below the federal rate that applies. If a corporation issues a shareholder or an employee a below-market loan, the lender's payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages or other payment, depending on the substance of the transaction. In these situations, it is not a true loan.

Reasonable Compensation. Because a corporation officer is commonly an employee with wages subject to withholding, they may question what is considered reasonable compensation for the efforts they contribute to their trade or business. The IRS warns it may determine corporations must make adjustments to the income and expenses of tax returns for both the business and an individual shareholder if the officer is substantially underpaid for services provided.

Further information about 'paying yourself' is available on the IRS website.