My answer to Is it better for the founder of a business to pay themselves as W2 employees or 1099 contractors?
Answer by Wray Rives CPA CGMA:
The answer is you don’t get to choose. At least you don’t get to choose directly. Founder pay will be determined by the form he or she chooses for the business itself. Compensation of the founder might be one factor (it should not be the sole factor) in determining the form of business entity, so let’s go with indirectly you decide how the founder is compensated when you decide the business structure. Choices and their impact are as follows:
- Sole proprietor. This might be a single member LLC or simply a single person operating the business with no legal structure. The impact is the same, the owner cannot be an employee of the business. The business can have other employees, but not the owner. All net profits of the business flow through as self employment income to the individual owner. Even if you have an LLC, when the business earns money, the owner earns money and the founder pay is the money earned. The owner cannot defer income by not taking a distribution from the business.
- Partnership. A partnership might also be an LLC, but one with multiple owners or members or it might also just be an agreement between two or more individuals to conduct business together. Much like a sole proprietor, partners in a partnership cannot be employees of the business. All net profits of the business flow through to the owners and like a sole proprietorship, when the business has earnings, the owners (partners) have earnings.
- C Corporation. A corporation is a separate tax entity from the owner and presumably the founder/owner of the corporation would be an officer engaged in operating the business and as such, he or she has to be a W2 employee and cannot be treated as an independent contractor. The only other founder pay from a corporation he owns is through dividends and in a closely held corporation, you generally want to avoid dividends, due to double taxation.
- S Corporation. An S corporation is a unique type of tax status that has some characteristics of a corporation and some characteristics of a partnership. Assuming the owner/found of the S Corporation is involved in operating the business, then the owner must be paid reasonable compensation as a W2 employee, much like a corporation. There might be earnings left over after paying the owner’s salary and those net profits flow through to the owner(s) of the S Corporation, similar to in a partnership with the one exception that those profits are not self-employment income, but rather non-earned income subject to income tax, but not self employment tax.