How to pay yourself as a business owner
How to pay yourself as a business owner
Understanding how to pay yourself as a business owner can be perplexing. When I started my business in 2003, I faced the same dilemma. Having worked in public accounting, I was accustomed to dealing with large businesses but not being the owner myself. Transitioning from receiving a paycheck to being the one writing the checks requires careful consideration of how to allocate funds for your own compensation.
When we engage with new clients who are first-time business owners, the question of paying oneself arises frequently. The answer to this question depends on the type of entity your business is, as accounting, payroll, and tax matters often vary depending on the specific circumstances.
How to pay yourself as a business owner and sole proprietor
If you operate as a sole proprietor, also known as a sole prop, SCH C, or single-member LLC, it’s helpful to envision two separate pockets—your business money and your personal money for how to pay yourself as a business owner. When paying yourself, you essentially transfer funds from one pocket to the other. Unfortunately, you cannot deduct this money transfer as an expense. Regardless of whether you move the funds or not, all the income generated before paying yourself is taxable. This withdrawal is commonly referred to as an “owner’s draw.”
How to pay yourself as a partner in a partnership
The second scenario that does not involve a conventional paycheck is if you are a partner in a partnership. Partnerships can take the form of general partnerships, limited partnerships, or the commonly seen structure of an LLC taxed as a partnership. Partnerships and LLCs file a separate tax return, and the profits or losses flow through to the partners via Schedule K-1. In this case, the partnership itself does not pay taxes, and each partner reports their share of income on their personal tax return.
Like sole proprietorships, partners can easily transfer funds from the business bank account to their accounts without immediate income tax consequences. Regardless of whether you withdraw or leave the profits in the business, you must report and pay taxes on the business’s profits. This method of compensation is known as a “partner or member draw,” and it is not reflected in the business’s profit and loss statement. It’s important to note that this draw is also non-deductible.
Compensation through Guaranteed Payments
Alternatively, partners can receive compensation through Guaranteed Payments, which can be distributed equally or unequally. Guaranteed Payments allow for compensating a partner who actively works in the business, even if they have the same ownership percentage as a non-working partner. These payments are treated as business expenses in the profit and loss statement and are reported as income by the partner receiving them.
It is crucial to avoid the common mistake of placing partners on the payroll of the partnership. Partners should never receive salaries or wages reported on a Form W-2, as it can lead to overpayment of non-refundable social security and Medicare taxes. The IRS emphasizes this point, as partnership income, including guaranteed payments, is subject to self-employment taxes and federal income taxes.
How to pay yourself as a business owner of an S corporation owner
For how to pay yourself as a business owner operating an S corporation, which can also include LLCs that have elected to be taxed under subchapter S, paying a reasonable salary for the services performed is a crucial aspect. Additional profits beyond the salary can be distributed to owners as stockholder distributions without incurring payroll or self-employment taxes. S corporations must file a separate tax return, and the profit or loss flows through to the owners via Schedule K-1.
An S-corporation that is not profitable is not required to pay a salary to its owners. “Reasonable salary” is a subjective term, but should be comparable to the amount you would pay an unrelated party for the same services you perform for the business. In most cases, the maximum that needs to be paid via salary would be the Social Security wage limit ($147,000 for 2022), but lower amounts can certainly be justified depending on circumstances. Owner salaries, like other salaries and wages paid, are a business expense, shown on the profit & loss statement and deducted as expenses on the tax return.
Additional profits of the business can be paid to the owners via stockholder distributions without any payroll or self-employment taxes to pay – this is what makes S-corporations an attractive option. S-corporations must file a separate tax return, with the profit or loss flowing through to the owners on Schedule K-1. Once a salary has been paid, remaining profits can be paid to owners as stockholder distributions with no further tax effect. As with the other forms of business covered so far, you must report and pay taxes on the profits of the business, whether you withdraw the profits or not. Much like sole proprietorships and LLCs, owners can simply transfer funds from their business bank account to their personal accounts, usually with no income tax effects (income tax payments paid for the owners are also treated this way). This is considered a “stockholder distribution” and is not shown on the profit & loss statement for the business. The big limitation is the idea of basis, simply meaning, do you have skin in the game to take the distribution? Basis is determined differently if you are a partnership or an S Corporation, so this will impact the number of distributions that are not additionally taxed.
A very important difference from partnerships – S-corporation distributions must be paid to ALL owners, according to their ownership percentages. Unequal stockholder distributions will void the business’s S-election. If there are unequal distributions, the accounts should be equalized via recording loans to stockholders if necessary and corrected as early as possible.
How to pay yourself when you are a C-Corporation
So you’re a corporation, or an LLC that has made an election with the IRS to be taxed as a C-corporation. C-corporation is the default tax classification for corporations unless they elect S status. C-corporations file their own separate tax return and pay their own tax – profits/losses do not flow through to the owners. C-corporations are generally unattractive to small business owners since there are limited ways to withdraw profits from the business without paying additional taxes on the funds.
The most common way owners of C-corporations withdraw funds is via salaries to the owners. Salaries are reported as expenses of the business on the company’s profit & loss statement and tax return. Payroll taxes are paid on the owners’ salaries as with any other employee and they report the salaries via Form W-2 on their personal tax returns. The IRS takes the opposite view from S-corporations on salaries for C-corporation owners – they want to keep the salaries to a minimum. They want reasonable salaries to be as LOW as possible since the net effect is a wash when calculating income taxes (deduction to the business, income to the owner) – this is a common audit issue, and C-corporations have higher audit rates than flow-through entities, such as LLCs and S-corporations.
Once salary payments have been maximized, the corporation can pay dividends to its owners according to ownership percentages. Dividends paid are not deductible to the corporation, but are taxable to the owners, so there is a second layer of taxation for these withdrawals. Owners generally pay tax on the dividends at lower tax rates applicable to qualified dividends (capital gains tax rates)
If owners leave excess amounts in the C-corporation as retained earnings and don’t withdraw profits as dividends or salaries, the IRS can impose an Accumulated Earnings Tax. This encourages companies to pay out dividends (which are double-taxed) rather than retaining their earnings. To avoid this tax, the business must be able to prove that the funds retained are needed to meet its business needs.
Other ways of getting money out of your business include indirect payment of other business-related expenses, which also benefit the owners. This includes: vehicle-related expenses, retirement benefits, health insurance payments, cell phone benefits, internet expenses, etc… Please consult your tax advisor for additional information if needed.
Remember: do NOT pay for non-business expenses from your business accounts
Please note, for all these forms of business, it is never a good idea to pay for personal (non-business related) expenses directly from your business bank accounts. It’s always better to transfer money to your personal accounts and then pay your expenses from there.
How to track basis
For partnerships/LLCs and S-corporations, your basis in the business is an important consideration when getting money out of the business. You should track your basis as part of your annual income tax preparation process. In general, if you don’t withdraw more money than you put in, plus the business’s taxable profits, the basis won’t ever be an issue for you. For S-corporations, borrowed money does not increase your basis, so if you withdraw borrowed funds, there could be a basis issue. If withdrawals are greater than your basis, you could have to pay capital gains tax on the excess withdrawals, so please consult your tax advisor when making withdrawals in excess of profits.
More questions? Just ask!
Many questions come to mind when you start running a business for the first time. “What insurance policies do I need?”, for example. Paying yourself, or getting money out of your business, is one of those many simple yet potentially confusing processes you want to get right. Hopefully, this article helped you classify where you stand in your own business. If you still have questions, click that Let’s Chat button to get the conversation started.