Equity - Profitable S-Corp

[Ty-aloha]

Hi,

I run/own a small online business. My partner and I are currently full-time, but our equity percents are different, in large part because one of us came onboard a couple of years after foundation and then was part-time for a year before leaving their other job.

We are now quite profitable. We had agreed to split revenues/profits equally until we both were at "full salary." (technically, some of our "salary" is W2 and the rest just bank transfers as profit draws, which is more tax advantageous, even if we weren't yet otherwise "profitable")

We've now passed the threshold of "full salary" (mixture of W2 and profit bank payments) Should profits above this threshold be dispersed based on equity percents? Is there something inherently unfair or improper about that? We generally feel our roles are more-or-less equal now, but the equity reflects the initial risk / foundation / product & market fit / more unpaid years by original founder. We may not sell the business one day, so otherwise the equity wouldn't come into play with an acquisition.

Thanks!

[CareCPA]

If you are an S Corp, all distributions must be pro-rata based on ownership percentages. You don't have the flexibility to pick and choose the percentage that gets distributed to each person.
If you have not done this in the past, you are at high risk of invalidating your S Corp election.

Note: this is just for distributions. You can do whatever you want for W-2 wages as long as it falls within "reasonable compensation."

[Ty-aloha]

Right. I think my (mostly non-tax/legal) question is if we roughly believe we deserve similar salaries early on, then is it fair if one us makes more now than the other based on having higher equity for profit distributions? Or should we decrease the salary/W2 of the person with higher equity to remain equal?

Larger startups perhaps don't face this as much because 1) profitability remains elusive, 2) profits are reinvested in the company, and/or 3) salaries are paid strictly as W2 (whereas as a small 2 person company we do minimum W2 as "reasonable salary").

Not sure if that makes sense...

[CareCPA]

Ah, this sounds like more of a "fairness" question than a technical question.
Personally, I'd be inclined to split profit based on effort and risk. Sounds like your efforts and risk are fairly equal now. However, does the person who took the higher risk at the beginning feel like they were properly compensated for it?

This is why I try really hard not to bring on equity partners. It's much easier to agree to a salary amount than to figure out equity splits.

[LWYRUP]

You can always adjust the equity splits if you so choose.  I don't know whether that would need to be structured as a sale with taxable consequences or just could be done as an issuance of more shares or membership interests in return for "sweat equity," resulting a dilution of the other owner.  I suspect there are ways to do it that are not taxable but it not my area of expertise. 

Whether it's fair or not...  that's in the eye of the beholder.  Perhaps you could look into how other small online businesses structure things and use that as a model. 

[BicycleB]

I can't speak to the legalities, am just offering comments on fairness and my perception of precedent.

-I agree early founder should get something extra for initial sweat equity. Has he/she received salary for that yet? If not, how about having the S corp provide some back pay until the founder has been compensated. After that, pay salaries according to ongoing contribution.

-I thought the purpose of equity was not just to share profits in the event of sale, but also to distribute profits in the event of earning more than the amount that would normally be awarded as salary. If you now have excess, the logical thing would be to pay fair market salary for current work, and divide the additional income as profits (more technically dividends, I think), which naturally would be divided by equity %. If the founder has more equity, this profit, not back pay, is their compensation for early work.

-If you can legally do so, to me it seems that using either option above (back pay or dividends) is acceptable as long as you're both satisfied.

-Great case in the sense that it shows why you're suppossed to be clear on examples like this beforehand. Since it's too late for that, my suggestion is find an implementation of the existing agreement that would be satisfactory to both parties, or agree to rewrite the agreement in a way both feel is fair. If you can't do this, the aggrieved party has to decide whether to stay or go, and both parties have to deal with the consequences.

Are you the founder or the joiner? If the joiner, do you want more compensation than the agreement entitles you to? If the founder, do you feel guilty about the prospect of getting a bigger % than the joiner?