No, partners cannot be compensated with a W2 salary

[Michael Plaks]

After answering this Q for the 100th client, I decided to make the answer public.

The situation: You are one of the two partners, and you work pretty much full-time as the project manager for the company. Your partner agrees to compensate you for this job and then split whatever is left 50/50. 

The problem: Since you're a partner, you cannot draw a regular W2 salary. 

The solution: You need to start what is known as Guaranteed payments for services. It is similar to W2 in the sense that you're getting a regular paycheck, but this is where the similarity ends. Unlike with a W2 payroll, nothing is taken out of your paycheck for taxes, and the company does not pay any portion of your taxes. As a result, it ends up very similar to 1099 compensation: you get the full paycheck for your entire gross compensation, and you will owe the IRS income tax plus self-employment tax on the entire pay.

Example: let's say that your compensation is $48,000 annual, and you're paid twice a month. This comes to $2,000 per each of the 24 pay periods.

W2 scenario:

• your company takes half of your FICA (Soc Security + Medicare) tax out of your paycheck. This is 7.65%, or $153
• your company takes out your Federal withholdings, estimated based on the W-4 form you completed. It varies, but let's assume it to be $300.
• your actual paycheck is $2,000 - $153 -$300 = $1,547
• your company sends your $153 portion of FICA to the IRS, and it adds another $153 out of the company money for the other half of FICA
• your company also sends your $300 to the IRS
• at the end of the year, you will have already paid all of your FICA ($7,344 if you care), half of it from your paychecks, and the other half from the company money
• you will have pre-paid $300 x 24 periods = $7,200 of your income tax to the IRS. If this ends up being not enough, you will owe the difference to the IRS on April 15th. If this ends up being too much, you will get a refund from the IRS.

Guaranteed payments (or 1099) scenario:

• your paychecks will be the entire $2,000 per period, nothing taken out
• you finish the year without anything prepaid, and you will owe the IRS $7,344 FICA (called self-employment tax in this case) plus whatever your income tax will be, possibly close to our $7,200 estimate.
• you end up paying more than in the W2 scenario, because the company does not pick up half of your FICA, as they do with W2. This is 7.65%, or $3,672 extra in this example.
• you can't wait until April 15 to pay all this money. The IRS wants you to prepay this hefty sum in 4 quarterly installments (aka estimated payments), starting April 15 of the current year, one year before your tax return is due

As with most tax issues, there's more to this setup than I described, but it's a start. 

Bottom line: do NOT set up W2 payroll for partners! W2 payroll is for the non-owner employees or for corporate shareholders, both S-corp and C-corp. Partners need guaranteed payments.