Let's start by exploring how S Corporation handle different income splits when there are multiple partners involved.
When you have an S Corporation, you must allocate and distribute profits to shareholders based on their ownership percentage. For example, if you and your partner each own 50% of the S Corporation, all distributions must also be 50-50, regardless of individual contributions or production levels. Did you work while your partner went on an exotic vacation? It does not matter! You will still receive only 50% of the income.
However, if your entity was a partnership and not an S Corp, you could choose to allocate profits differently from ownership shares. In a partnership, you and your partner can split income based on how much each of you worked and earned, rather than equally.
Balancing Income allocations in S Corps: If you want to balance income differently but remain an S Corporation, consider adjusting salaries and paying the hard-working partner extra. For example, if you want a 55-45 income split but are 50-50 owners, you can set salaries to reflect the desired split. If one partner should receive 55% of the total income, adjust their salary so they receive more. However, higher salaries lead to higher payroll taxes, which can be costly. Just remember: for every additional $10,000 in salary, expect to pay about $1,500 in payroll taxes.
Alternative Solution: To avoid high payroll taxes, some business owners use a workaround. They establish a holding company (lets pick a partnership for illustration purposes), where each S Corporation is a member, and each S Corp is 100% owned by its respective business owner. The partnership collects all the revenue and its turn it allocates income to the S Corps based on the work performed. The partnership also pays for common expenses that need to be split among all partners (such as professional fees, rent, software, etc). In turn, each S Corp determines reasonable compensation for its owner and pays for expenses specific to that S Corp, such as cars, business use of the home, etc. The S Corp may also pick up some other income that it earned separately from the holding company. At tax time, the partnership issues K-1s to each S Corp, reflecting their share of net income. Then, each S Corp issues K-1s to its owners, showing both net income from the partnership and S Corp expenses that were incurred independently from the other members.
Second Alternative Solution: This strategy again involves creating two types of entities: a holding company (again, lets pick a partnership for illustration purposes), which this time is owned by individuals directly. Income first flows to the partnership, and the S Corps issue invoices to the partnership for their professional services, equal to the business income minus common expenses split among all members. The partnership pays the invoices and reduces its income to zero or a nominal amount. Payments from the partnership to the S Corps are recorded as payments for services rendered. As a result, each individual receives two K-1s—one from the partnership with a small amount and another from their respective S Corp.
These types of arrangements work very well if you don't want to be restricted by other partners. Partners can have their own separate business expenses that do not need approval of other partners. You would only need to figure out how common expenses are calculated between partners. And of course, partners get to keep the benefit of reasonable compensation, which is the whole idea behind S Corps.
Please note: do not issue 1099s in this scenario. A 1099 is only required for non-corporate entities. Once your LLC elects S Corp status, it's considered a corporation for tax purposes, so your vendors aren’t required to send you a 1099, though some might. Also, 401(k) plans in this situation are tough since it is a controlled groups.
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