Owner's Compensation Glossary

Reasonable Salary

The IRS-required compensation that S-Corp owner-employees must pay themselves through payroll for services they perform. Must reflect fair market value for the work, what you would pay an unrelated person to do the same job. Taking only distributions and no salary is a common audit trigger. Your NCO advisor will help you determine a defensible amount.

QBI Deduction (Qualified Business Income)

A federal-only deduction of up to 20% of qualified business income available to sole proprietors, partners, and S-Corp shareholders. Not available in California. Subject to income limits and business-type restrictions. Reduces federal taxable income but does not affect self-employment tax.

Self-Employment Tax

A federal tax of 15.3% on net self-employment income, 12.4% for Social Security and 2.9% for Medicare. Sole proprietors and partners pay this in place of FICA because there is no employer to pay the other half. You can deduct half of SE tax on your federal return. Does not apply to S-Corp distributions or C-Corp salaries.

Owner's Draw

For sole proprietors and single-member LLCs, money withdrawn from the business for personal use. Not a business expense. Not taxable at the moment of the draw (tax is owed on business profit regardless of how much you draw). Recorded as a reduction in equity.

Guaranteed Payment

A fixed payment made to a partner in a partnership or multi-member LLC for services rendered, regardless of whether the partnership is profitable. Deductible to the partnership as a business expense; taxable as ordinary income to the partner. Subject to self-employment tax.

Distribution

A payment of profit from a corporation (or pass-through entity) to its owners. In an S-Corp, distributions above reasonable salary are not subject to FICA, this is the primary tax advantage of the S-Corp structure. In a C-Corp, distributions to shareholders are called dividends and are subject to double taxation. Distributions are not a business expense.

Constructive Dividend

When the IRS determines that a transfer from a corporation to a shareholder, typically an undocumented loan or personal expense paid by the company, was actually a distribution of profit rather than a legitimate loan. The amount is treated as taxable dividend income to the shareholder, with no deduction for the corporation. Common result of shareholder loans that lack documentation or are never repaid.

Retained Earnings

Cumulative corporate profit that has not been distributed to shareholders. Sits on the Balance Sheet as equity. Can be held indefinitely, reinvested in the business, or distributed later as dividends or S-Corp distributions. Retaining earnings in a corporation defers personal income tax but does not eliminate it.

W-2 (for owner-employees)

The annual wage and tax statement issued to owner-employees of S-Corps and C-Corps. Reports total wages paid and taxes withheld (federal income tax, Social Security, Medicare). S-Corp owners receive a W-2 for their salary portion; their distributions do not appear on a W-2. Used when filing your personal income tax return.

S-Corporation

A pass-through tax election available to qualifying corporations. The corporation itself does not pay federal income tax, profits and losses pass through to shareholders and are reported on their personal returns. Requires owner-employees to take a reasonable salary through payroll. California S-Corps pay a 1.5% franchise tax on net income. The main tax advantage over a sole prop or partnership is that distributions above salary are not subject to FICA.

Pass-Through Income

Business income that is not taxed at the entity level but instead passes through to the owners' personal tax returns. Applies to sole proprietorships (Schedule C), partnerships (Schedule K-1 via Form 1065), and S-Corps (Schedule K-1 via Form 1120-S). C-Corps are the exception, they are taxed at the corporate level first. Pass-through income is subject to federal and California personal income tax rates.