How to Pay Yourself as a Small Business Owner
After you start your own business, paying yourself for all the time and effort you’ve put in is an exciting moment. But how do you pay yourself as a small business owner?
You might think of the payments you take from the business as your salary, but most small business owners don’t take their pay as a salary. In fact, there are up to four ways to pay yourself as a small business owner:
- Draws
- Guaranteed payments
- Salary
- Distributions or dividends
The method (or combination of payment methods) you choose depends on how your business is structured.
Sole Proprietors, LLCs and Partnerships
Sole proprietors and members of partnerships and LLCs are free to pay themselves whenever they’d like. They’re not required to pay a regular salary or withhold income and payroll taxes, although they are responsible for making estimated quarterly payments of income and self-employment taxes.
As a sole proprietor, partnership or LLC member, the money you take out of the business for your personal use is considered a draw, which reduces your share of equity in the business. Draws are not deducted as a business expense.
Partnerships have another option: guaranteed payments. Guaranteed payments are used to pay partners for the work they do in the business, but they aren’t based on the percentage split agreed upon in the partnership agreement. Unlike draws, guaranteed payments are deducted as a business expense.
As a sole proprietor, partner or LLC member, regardless of how much you pay yourself, you pay income taxes and self-employment taxes on your share of profits from the business.
S Corporations
Owners of S Corporations (and LLCs that have elected to be taxed as an S Corporation) receive a regular paycheck with income and payroll taxes withheld, just as other employees of the company do. One of the benefits of structuring your business as an S Corp is that while you pay income taxes on your share of business profits, you pay self-employment taxes only on your salary. For some business owners, this can result in a significant tax break.
S Corp owners can also take additional compensation in the form of a draw or distribution. The key is finding the right balance between salary and distributions. The IRS doesn’t like S Corp owners who pay themselves very small salaries and big distributions solely to avoid self-employment taxes. It requires S Corporation shareholders to pay themselves a “reasonable compensation” for the work they perform.
Although the IRS doesn’t have hard and fast rules about what constitutes reasonable compensation, a good starting point is to consider what another business would pay someone to perform similar work.
C Corporations
Officers of a C corporation (and LLCs that have elected to be taxed as C Corporations) are considered employees of the corporation and receive regular paychecks with income and payroll taxes withheld. Owners can also receive dividends from the corporation. As a result, C Corp profits are subject to “double taxation,” meaning the corporation pays taxes on profits and the officers pay taxes on those profits again when they are distributed out as dividends.
C Corp officers have an incentive to avoid double taxation by “zeroing out” the income of the corporation by paying officer salaries and bonuses that absorbed all the company’s profits. However, the IRS may scrutinize a return if it appears the corporation is paying excessive compensation to shareholders to avoid corporate tax rates.No matter which form of business you choose, deciding how much you pay yourself is about finding a balance between how much money you need to live and how much your business needs to operate. Need help determining a reasonable salary? Feel free to set up a call with me! I can help you navigate the tax laws and take advantage of tax-saving opportunities.
