Getting paid when you’re no longer in charge

Uninvolved owners can receive profit distributions instead of salaries, but mind the legal and financial fine print.

Antonio Costa, West Palm Beach, Fla.
I have two uncles living in Florida who co-own a successful business up north. Although they stopped running day-to-day operations about four years ago, they still receive full salaries. Because they no longer run the business, can their salaries become dividend payments instead? Can they still receive dividends if the S-corp shows a loss?

By Meg Massey, Fortune Small Business contributor
Dear Antonio: Before you attempt to work out an alternate form of payment for your uncles, make sure you understand the nature of their affiliation with their business. While they may no longer make daily decisions, they could still be waiting out contracts.

“If your uncles have employment contracts with the company, the business may be bound to pay them salaries until those contracts expire,” says Jonas Grant, a business lawyer based in Burbank, Calif.

Are they still occupying titular roles as directors or officers? If so, “they do ultimately run the business, regardless of whether they’re handling day-to-day operations,” says Grant. In this case, they would still be worth salaries in the eyes of the IRS.

Double-check that your uncles are completely uninvolved with the company. “They can take profit distributions (the equivalent of dividends in an S-corporation) in lieu of salaries if they aren’t providing any services,” says Kerry Bingaman, a CPA in St. Petersburg, Florida. Ask your uncles to be 100% transparent with you about their interactions with the business.

Once you’re clear about their lack of contracts, titles, and services, you can encourage your uncles to accept profit distributions instead of salaries. If they’re the only shareholders, it’s easy to make the switch.

“They should stop taking salaries and start taking distributions, depending on the company’s profits, or retained earnings,” says Bingaman. “Distributions must be pro-rata based on the ownership held by all shareholders. They should not exceed retained earnings, or they may have capital gains on the distributions.” She adds: “If there are more shareholders involved, the answer could be different.”

It’s impossible for them to receive any profit distributions in a year in which the corporation shows a loss. “S-corporations are pass-through tax entities, so their profits or losses after expenses are distributed to shareholders in accordance with their ownership interests,” says Grant. So before you encourage your uncles to drop their salaries in favor of distributions, find out how the business is doing – and consult with a CPA.

Give us your advice: Check out recent “Ask & Answer” questions.

Related links:

Scrimping on your salary? Beware an audit

Do salaried workers get overtime?

Solve 5 top accounting annoyances