URL: http://www.entrepreneur.com/article/73368
When your business initiates a company-sponsored retirement plan, the way in which you choose to be compensated will affect your ability to actively participate by making annual contributions to the plan. In fact, you must have current year earned income in order to make current year tax-favored contributions to a company-sponsored retirement plan, such as a Simple IRA, a SEP (Simplified Employee Pension), a 401(k) or a KEOGH.
As a business owner, if you compensate yourself using earned income, you qualify for active participation in a company-sponsored retirement plan. However, this also creates a tax liability for self-employment tax at 15.3 percent of earned income.
Alternatively, if you pay yourself a return on investment (ROI), this ROI isn't considered earned income, and although this doesn't qualify you for active participation in a company-sponsored retirement plan, it does have the benefit of not creating any self-employment tax liability for you.
The following is a summary of owner compensation--by type of business organization--indicating whether this compensation represents earned income or ROI:
- Sole proprietorship: The bottom-line profit is all considered earned income, even if it's not distributed to the owner.
- One-member LLC (taxed as a sole proprietorship): The bottom-line profit is all considered earned income, even if it's not distributed to the owner.
- Multimember LLC (taxed as a partnership): In a multimember LLC, there are two types of members: a managing member, who manages the activities of the LLC, and members, who are typically only investors. The managing member is considered the active owner; therefore, his pro-rata share of bottom-line profit is considered earned income, even if it's not distributed to him. Members are considered inactive owners; therefore, their pro-rata share of bottom-line profit isn't considered earned income, but rather a return on investment. All members pay tax on their pro-rata shares of bottom-line profit at their respective member's individual marginal income tax rate. Additionally, members can be paid guaranteed payments for actual work performed--and these payments are considered earned income to the recipient.
- LLC (taxed as a C corporation) or a shareholder in a C corporation: The profits of the business aren't considered earned income, but rather are considered a return on investment and are taxed at special corporate income tax rates. The owner can only create earned income if the business pays him W-2 wages for actual work performed. Dividends paid are considered a distribution of the shareholder's ROI.
- LLC (taxed as an S corporation) or a shareholder in an S corporation: The LLC member's, or S corporation shareholder's, pro-rata share of profits of the business isn't considered earned income, even if it's not distributed to the owner; rather, it's considered a return on investment and is taxed at the respective owner's individual marginal income tax rate. Additionally, the owner can only create earned income if the business pays him W-2 wages for actual work performed.
- General partnership: All partners are considered active owners; therefore, their pro-rata share of bottom-line profit is considered earned income, even if it's not distributed to the partners. Additionally, partners can be paid guaranteed payments for actual work performed--and these payments are considered earned income to the recipient.
- Limited partnership: In a limited partnership, there are two types of partners: a general partner, who manages the activities of the partnership, and limited partners, who are typically only investors. The general partner is considered the active owner; therefore, his pro-rata share of bottom-line profit is considered earned income, even if it's not distributed to him. Limited partners are considered inactive owners; therefore, their pro-rata share of bottom-line profit isn't considered earned income but instead is considered a return on investment, even if it's not distributed to the limited partners. All partners pay tax on their pro-rata shares of bottom-line profit at their respective partner's individual marginal income tax rate. Additionally, partners can be paid guaranteed payments for actual work performed--and these payments are considered earned income to the recipient.
As the owner of your business, it's up to you to decide whether your compensation will be earned income or a return on investment. After you make this choice, you'll then have to consider the most favorable way to implement this decision--given your existing form of business organization. And depending on the circumstances, you may even want to consider changing your form of business organization to help you accomplish your goals.
Note: The information in this column is provided by the author, not Entrepreneur.com. All answers are general in nature, not legal advice and not warranted or guaranteed. Readers are cautioned not to rely on this information. Because laws change over time and in different jurisdictions, it is imperative that you consult an attorney in your area regarding legal matters and an accountant regarding tax matters.
David Meier is the founder and COO of Business Development Coaching, a company that provides small-business owners with ongoing business coaching.