When I first started my business/firm in 2003, I didn’t know how I was supposed to pay myself. It was probably because I hadn’t paid enough attention in school, but I really didn’t know. I had worked in public accounting for seven years, and nearly all of that time was working on large businesses, so most weren’t owners. A few were, but they were a CEO of major businesses– WAY different than me when I started my business.
I vividly remember wondering if I needed to be on my business’s payroll. I quickly figured it out, but I share this story because wondering about this is a normal question new business owners have. You are not alone. If you have been working for someone else your whole career, more than likely you have been receiving a paycheck and now—well, you’re the one writing the paycheck. And yet, getting money out to yourself is still super important. After all, how could you put yourself through all of these other challenges of leading a business without making sure to put a little money in your own pockets?
When we bring on new clients that are first-time owners, this is probably the most often asked question. That is, as long as our client isn’t afraid to ask what they think may be a stupid question. The answer is totally logical once we walk through it, but it takes a little thinking through. Before we can answer it though, we have to know what type of entity you are. This is because, as most answers are when it comes to accounting, payroll, or tax , the answer is… it depends.
How to pay yourself when you are a sole proprietor
If you are a sole proprietor (also known as sole prop, SCH C, or single member LLC) you should think of the idea that you have two pockets. One pocket is your business money and one pocket is your personal money. When it comes to paying yourself, you simply are moving money from one pocket to the other. Unfortunately, this means you can’t deduct the movement of this money to yourself. Regardless if you move it or not, everything you make before you pay yourself is taxable to you. This is simply referred to as an “owner’s draw”, or more commonly referred to as just a “draw.”
How to pay yourself when you are a partner in a Partnership
The second scenario without a typical paycheck is if you are a partner in a partnership. To be a partner in a partnership, you could be a partner in a general partnership, limited partnership, or the most common partnership we see: a member in an LLC that is taxed as a partnership (This is the default method for an LLC unless you make an election to be either an S Corp or C Corp).
Partnerships and LLCs are similar to a sole prop in that it’s simple to pay yourself. Partnerships and LLCs must file a separate tax return with profits or losses flowing through to owners on SCH. K-1. This means that the actual partnership doesn’t pay tax, but rather the partner shows the income on their tax return and pays tax based on the reporting of the income on their own return.
Much like sole proprietorships, 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). You report and pay taxes on the profits of the business, whether you withdraw the profits or not. This is considered a “partner or member draw” and is not shown on the profit & loss statement for the business. And once again, you don’t get to deduct what you are paying yourself for this classification.
Guaranteed payments
Alternatively, partners can be compensated via Guaranteed Payments (can be equal or unequal). For example, guaranteed payments can be used to compensate a partner who works in the business, but owns the same percentage of the business that a non-working partner owns. Guaranteed Payments are shown as an expense of the business on the profit & loss statement and on the tax return for the business. The partner being compensated picks up income for the Guaranteed Payment they received.
A very common issue we see when bringing on new clients is that a partner is on the payroll of the partnership. Partners are never to be compensated via salaries or wages that are paid and reported on a Form W-2. This can cause an overpayment of non-refundable social security and Medicare taxes, and disproportionately impact other partners from having their respective share of income. Likewise, payroll taxes should never be paid on partner compensation in this way. This is a common error, but the IRS is very clear on this matter. Partnership income (including guaranteed payments) is 100% subject to self-employment taxes typically for active businesses plus federal income taxes.
How to pay yourself when you are an S Corporation
S-corporations are C-corporations, or LLCs that have made an election with the IRS to be taxed under subchapter S. S-corporation owners must be paid a reasonable salary for the duties they perform. 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.
An S-corporation that is not profitable is not required to pay a salary to its owners. Reasonable salary is a subjective term, but generally 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.
Stockholder distributions
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 amount of distributions that are not-additional 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 this:
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.
The basics of tracking 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 taxable profits of the business, 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.
There are tons of questions that 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 that you want to get right. Hopefully, this article helped you classify where you stand in your own business. If you still have questions, feel free to reach out to us using the Let’s Chat button at the bottom of this article. Or, explore another common question we get from business owners in our blog: What Type of Bank Account Should You Have?
