Bookkeepers: What you need to know about legal entities and owner compensation

Are you ready to take your bookkeeping knowledge to the next level? As bookkeepers, our clients come in an assorted variety of legal entities. Legal entities and owner compensation might not sound like the most exciting topic, but trust me, it’s essential knowledge for any bookkeeper looking to grow, gain confidence, or tackle clean-up projects. Understanding your client’s legal entity and how they should be compensated can make a world of difference in your work with US clients. Today I’ll help explain the different tax forms and compensation methods for each type of legal entity, including Sole Proprietorships, LLCs, S Corporations, Partnerships, and C Corporations. So keep reading or click the video below to hear my insights for bookkeepers: what you need to know about legal entities and owner compensation.

So what does it matter for bookkeepers to know the type of legal entity of their clients? In the US, it’s very important for you to know how the company is set up for tax purposes. It affects how you set up the books. It’s also very important to know how the owner is compensated.

As you’ll see below, there are different ways in which owners are compensated based on how the entity is set up for legal and tax purposes. I’ll go over each of those with you so that you can feel more empowered and more confident when working with your bookkeeping clients.

Sole Proprietorship

Let’s start with the Sole Proprietorship. The tax form filed is a Schedule C, and that is on an individual’s Form 1040. The owner is taxed on the company’s taxable earnings. The owner may take distributions, but the owner doesn’t take any payroll.

Limited Liability Corporation (LLC)

Next, we have a Limited Liability Corporation, or LLC. Many business owners you ask about their legal and tax setup will often mention being set up as an LLC. For IRS purposes, an LLC is considered what we call a “disregarded entity”, which means there isn’t an IRS tax entity for an LLC. An LLC is used at the state level, not the federal or IRS level. So, if that business owner doesn’t make any other election to be taxed in a different way, they’re going to file a Schedule C or be taxed as a Sole Proprietorship. The owner compensation is the same as the Sole Proprietor.

S Corporation

Next, we have an S Corporation, or S-Corp. The tax form filed by the S Corporation is an 1120S. The company’s taxable earnings pass through to the shareholder’s tax return. That means that the S Corporation does not pay income taxes or federal income taxes. But, the income taxes are paid by the shareholder or the S Corporation owner. The shareholder may take distributions and should take what we refer to as a “reasonable compensation” if they’re active in the business.

General Partnership

Now, we have a General Partnership. The tax form for this entity type is a 1065 form. The company’s taxable earnings, again, pass through to the partner’s tax return. The partners receive what’s referred to as “guaranteed payments” which are expensed on the books. The partners do not receive payroll. So, as opposed to an S Corporation where the owner or shareholder of the business receives payroll and distributions, partners do not receive payroll. Distributions for partners are based on the partnership agreement.

C Corporation

Then, we have a C Corporation, or C-Corp. The tax form filed for this entity is an 1120. As for compensation, stockholders are paid dividends and stockholders who are employees of the Corporation are paid salaries.

LLCs Taxed as S-Corp, C-Corp, Partnership

For the next three entity types, we’ll look at LLCs taxed in various ways. Remember, I said LLCs are considered disregarded entities for federal income tax purposes. If the LLC owner doesn’t make any election for tax purposes, they will be taxed as a sole proprietor. But they have options to be taxed as an S Corporation, a Partnership, or a C Corporation, depending on whether they qualify for those different elections.

For an LLC taxed as an S Corporation, the tax form filed is an 1120S. When they make that election for tax purposes, the taxation and compensation is treated the same. In this case, as an S Corporation.

If they’re an LLC and elect to be taxed as a Partnership, then the tax form they will file is a 1065. They will be taxed and compensated as a General Partnership.

Lastly, for an LLC taxed as a C Corporation, they’re treated the same as a C Corporation.

Closing and Resources

Now that I’ve shared my knowledge for bookkeepers: what you need to know about legal entities and owners compensation, I hope you will feel empowered and more confident with your clients. Remember this important question to start asking your clients: “How is your company set up for legal and tax purposes?” Their answer should reflect one of the legal entities we went over today. It will also determine how you set up their books and how they are compensated in their business. If this article has helped you better understand legal entities and owner compensation and you’d like to learn more about running a successful virtual bookkeeper business, subscribe to my YouTube channel and consider joining my 5 Minute Bookkeeping Community on Facebook and following me on Instagram. For even more free and paid courses and resources, including my free Virtual Bookkeeper’s Toolbox, you can visit my 5MB Academy, where we empower virtual bookkeeping pros to confidently grow as professionals and business owners.

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