You likely started your business for two main reasons: you are passionate about the venture and you want to make money. For some, one reason may be far more important than the other. Nonetheless, if you want your business to be successful, it needs to not only make money, but also be able to support you so you can continue the business.
Being able to pay yourself is one of the many joys of owning your own business. Depending on your business structure, you may be able to pay yourself whenever you need funds. In some situations, however, paying yourself as needed is not a good idea for tax purposes or to maintain your asset protection status.
How you should pay yourself will depend on how you have chosen to set up your business. Paying yourself in a sole proprietorship may look very different compared to paying yourself as the owner of a corporation.
Tracking your income is critical for tax purposes. You need to be able to show the IRS or state tax entities how much you are earning and how you are earning it. That means that you not only need to pay yourself in a specific way, but you may also need to use formal documentation to prove payments as well.
One of the primary reasons that individuals use corporate structures or LLCs is because of the asset protection that they provide. However, this benefit may be compromised if you do not pay yourself correctly. Keeping the business assets and funds separate from your personal funds is extremely important to maintain the integrity of the corporation or other business entity. Transferring funds back and forth between yourself and the business bank account can undermine these protections. As such, it is particularly important to pay yourself in a certain way in business structures that offer asset protection like corporations and LLCs.
The IRS requires that you pay corporate officers and owners “reasonable compensation.” It can be tough to determine what reasonable compensation may be for your role in your own business. However, how much you pay yourself can have a huge impact on your taxes and your business’s livelihood. If you pay yourself too much, you are taking money out of the company that could have been used for growth, expansion, or even everyday purchases.
On the other hand, if you pay yourself too little, you may not be able to get by on a daily basis. It may take some time to determine what an appropriate salary for you and your particular situation may be. You might want to start with an extremely low salary if you are just opening your doors to help ensure your business will have enough money for its expenses. You can always adjust it upward as your business grows.
Of course, even determining your minimum salary requirements calls for some careful planning and consideration. Having a good handle on your personal expenses can help with this process. If withdrawing the minimum is not an appealing option to you, you may still want to include some type of buffer in the business bank account for emergencies.
In some situations, if you are underpaying yourself, the IRS may adjust your reportable income to reflect how much you should be paid based on your title and role in the business. They do this to avoid situations where business owners do not take enough compensation to avoid paying income taxes.
Failing to pay required taxes can result in significant penalties and interest, particularly with regard to payroll taxes. To prevent potential problems with the IRS, you may want to do some research regarding what business owners in your industry are paying themselves as a salary.
When determining whether your wage is reasonable, the IRS may consider the following factors:
These are obviously the factors you should also consider when determining how much your salary should be. Careful consideration and planning today can go a long way toward helping you avoid potential future problems with the IRS.
Business owners can either pay themselves through salaries or as a dividend in a few business structures. You can also be paid based on both methods as well. The major difference between these income methods is how they are taxed. If the business owner chooses to take a salary and/or bonus, the individual will be taxed personally on his or her income tax return based on his or her regular tax rates. However, the business can take a deduction for any payment to its officers or other employees.
If the business owner chooses to take compensation in the form of dividends, the company will pay corporate tax on the income earned and the officer will still pay personal tax when the proceeds are distributed. This is true for both C corporations and LLCs that have elected to be taxed as a corporate entity. However, because individual dividend taxes are often lower than regular income taxes, there is a benefit for business owners to take compensation in this way.
Keep in mind that you do not have to be a public corporation to declare a dividend. Closely held corporations and S corporations can declare dividends as well. Other business structures cannot declare dividends. LLCs, for example, provide distributions rather than dividends.
Federal law requires that corporate officers be paid as if they are employees so that taxes and withholdings for Social Security and Medicare can be withdrawn. In some situations, however, corporate officers who are an officer in name and not really by role may not be treated as employees. For example, if you have officers that only work for a few hours every month or provide consultation services occasionally, you may not need to pay them as if they are employees. Paying them as an independent contractor might be a better option.
Whether you have a C corporation or an S corporation will also dictate how you should pay yourself. Officers of C corporations are strictly paid on a salary basis. They may be able to obtain bonuses, but their primary source of income is their salary. In an S corporation, an owner can choose to take regular draws or distributions in addition to their normal salary. These draws do not have traditional payroll taxes taken out.
Business owners can also choose to pay themselves in dividends. However, dividends cannot be taken as freely as regular draws, particularly if you have more than one shareholder or owner.
LLCs are flexible business entities because they can choose how they want to be taxed. By default, the IRS treats LLCs as “disregarded entities,” which means that single member LLCs are treated as sole proprietorships, and multimember LLCs are treated as partnerships. However, you can elect to have different treatment for tax purposes by filling out a specific form.
If you are under the default classification and have not elected to be taxed as a corporation, you cannot receive a salary from an LLC. Instead, you withdraw amounts directly from the business as necessary. Be sure to track these withdrawals because you will need to report them on your individual income tax return. Then, you will be taxed at self-employment tax rates for your withdrawals.
Keep in mind that as a disregarded entity, you are taxed on the company’s entire profit, not just what you take out of the business’s bank account. For some, this can be an incentive to over-withdraw, which can be a problem for the viability of your business moving forward.
If the LLC elects to be treated as a corporation, that changes how you should pay yourself as well. Take a look at the above rules regarding owner payments in corporations for more information.
General partnerships are technically not separate legal entities. Instead, they are an extension of the partners who operate them. This is true with regard to finances as well. Partnerships are not taxed at a separate rate, and income from the business is included on each partner’s regular income tax return.
Partners in a partnership do not take a salary, but they may choose to make periodic, consistent withdrawals for ease of accounting. Technically speaking, however, partners can withdraw funds as they please. Nonetheless, some practical complications arise when you pay yourself out of a partnership. For example, it would be unfair if one partner was permitted to withdraw funds more often or in larger amounts compared to other partners. For this reason, creating a general partnership agreement that sets out how much each partner will be paid and how often is an important practical step in forming your partnership.
Business owners who operate a sole proprietorship have the most leeway when it comes to paying themselves. As a sole proprietor, you can literally take draws whenever you want, for any amount that you want, with no oversight. This is incredibly appealing to most small business owners as there is no need to predict what salary they may require for their personal expenses and no need to impose strict limitations.
The freedom to withdraw as you please is extremely tempting for many business owners. Of course, you run the risk of overdrawing the business account so that it does not have enough funds to address ongoing business expenses if you overdraw. It is a good idea to keep withdrawals to a minimum when you are first starting out, so you do not accidentally spend profits you need to put back into the business.
As partnerships and sole proprietorships are simply extensions of the individual owners, they are not taxed like other business entities. You do not pay yourself a salary, which means there are no payroll taxes deducted from your payments to yourself.
Payments to Social Security, Medicare, and state and federal income tax authorities are not addressed in the payments you make to yourself in a sole proprietorship or partnership. Instead, you must track all of the payments you make to yourself and pay self-employment taxes on them at the end of the year. For 2017, the self-employment tax rate is 15.3%.
Payroll taxes are provided to the IRS on a quarterly basis by employers. Even though you are not technically employed by anyone, you must still meet these periodic payment obligations. If you do not make these required quarterly payments, you may be forced to pay penalties and interest on late taxes.
To avoid these extra costs, most self-employed individuals who operate under a partnership or sole proprietorship will make quarterly tax payments (often referred to as “estimated tax payments”) to the IRS and state taxing authorities. This requires setting aside a portion of your income to make these payments. Corporation owners often do not have to engage in this practice because they take taxes out automatically when they receive their salary.
At LegalNature, we know that the legal and tax implications of running your business can be extremely complicated. That is why we have built an excellent Help Center that you can use completely free. We also provide a broad range of legal documents that can help you ensure that your contract, lease, formation documentation, and more are accurate according to your state laws. Using these cost-effective resources means that you do not have to go it alone!