Are you on your business’ payroll, or do you take payment from your business in the form of owner draws? Do you and your business partner take guaranteed payments? What about regular profit distributions?
Are you taking enough money from your business? Are you taking too much? How can you tell? And where are your payments showing up in your business’ financials? Do you know why they are posted where they are?
Once you have answered the question of how to afford to pay yourself (hint: you have to set aside this money first), the questions then turn to the mechanics of how you should take those payments from your business.
How Does Your Business Type Affect How You Are Paid?
Small business owners often refer to the payments they take from their businesses as their salaries. However, most small businesses are not structured so that the owner can take all of their pay via a salary, at least not in the traditional sense.
How small business owners pay themselves depends on how their business is organized. Sole proprietorships, partnerships, S corps, and C corps all have different rules about how their owners, members, or shareholders are paid—and taxed.
Small business owners pay themselves in the following ways:
Seems easy, right? But why would you choose one type of business structure (and therefore, one type of payment) over another? That answer is a little more complex.
A small business owner must consider many factors when they form their business. Entity type determines not only how small business owners pay themselves but also how those earnings are taxed. Let’s take a closer look at entity structure and how that affects how small business owners pay themselves.
Before we get started, though, please note this article is a very high-level overview of complex subject matter and is for informational purposes only. You should consult your tax professional (CPA, EA, or tax attorney) about your particular situation.
Most small businesses are either sole proprietorships or what is known as disregarded entities, which basically means they are organized as LLCs (a state-level designation) but have not made an S corp election for tax purposes. For tax purposes, sole proprietorships and disregarded entities are not considered to be separate from the individual who owns the business, though an LLC designation can provide some protection to a business owner’s personal assets should a lawsuit arise.
What does all this have to do with how a sole proprietor pays himself? Because the business is not separate from the owner in the eyes of the IRS, all of the profit retained by the business is considered to be income to the owner. The owner is not allowed to deduct the payments they take from their business as business expenses. Instead, sole proprietors take their payments from the business in the form of draws. These draws should show up on the balance sheet under the equity section as negative entries. They do not appear on the profit and loss statement.
Since a sole proprietor or the owner of a disregarded entity is taxed on their business’ profits, and those profits are not reduced by any draws the business owner takes, sole proprietors must make sure they regularly allocate a percentage of their income to a savings account for taxes. This will help them avoid the unpleasantness of discovering they have a tax bill and not enough money to cover it.
As with sole proprietorships, partners in a partnership are taxed on the full profits in the business. These profits are split based on the partnership agreement.
For example, if a partnership shows a $100,000 profit and each partner owns 50% of the business, then each partner will be responsible for the taxes on $50,000. If, however, the partnership is split 70/30, then Partner 1 will be liable for taxes on $70,000 and Partner 2 will be liable for taxes on $30,000. The flip side to this is that Partner 1 is also entitled to 70% of the profits in the business, whereas Partner 2 is only entitled to 30% of the profits. These profits are paid to the partners in the form of distributions, or they are retained to increase the partners’ equity in the business. Either way, the distributions or retention of profits will show up on the balance sheet, not the profit and loss statement.
Partnerships have an interesting twist though: the guaranteed payment. Guaranteed payments are used to make payments to partners in a business for the work they do in the business, but they are not based on the percentage split agreed upon in the operating agreement for the business. And, unlike with draws and distributions, guaranteed payments do appear on the profit and loss statement and reduce the profits in the business.
Let’s say the operating agreement for the partnership stipulates Partner 1 is paid $25/hour for each hour they work in the business, and they typically work 1,000 hours per year. That $25,000 will show up on the P&L as guaranteed payments, and it will reduce the net income the business shows that year. Partner 1 will pay self-employment tax on that $25,000. The remaining net income, or profit, then gets distributed according to the operating agreement, and each partner pays taxes on their portion of the profits.
As mentioned previously, the owner of an LLC or the partners in a partnership can choose to make an election for the business to be taxed as an S corporation, more commonly called an S corp. Similar to the sole proprietorship or partnership, an S corp passes the tax liability on to its members or partners based on percentage of ownership, and the business itself has no tax liability.
S corp shareholders receive payment both in the form of a regular salary (which is included in payroll expenses on the P&L) and also through distributions (which appears on the balance sheet). S corp shareholders are typically also employees of the business.
They are added to the company payroll and subject to the same withholding tax guidelines as any other employee. This reduces the bottom line (what the shareholders pay taxes on) by both the amount of the shareholders’ salaries and the business’ portion of their taxes.
Any remaining profit is then paid out via distributions or used to increase each shareholder’s equity in the business, and that profit is generally taxed at a lesser rate than the self-employment tax rate.
The S corp is often seen as the best of all possible business worlds, and it can be if it is managed properly. There are, however, some possible pitfalls:
- S corp shareholders must receive reasonable compensation in the form of wages or a salary. While the IRS does not define “reasonable compensation,” a general rule of thumb is that the shareholder’s wages should be comparable to what they would pay an employee for the work they do for the business.
- The IRS tends to turn a more critical eye toward S corps than other business entities, with disproportionate salary/distribution combinations being a major target. If an auditor determines distributions should be reclassified as wages, you could be subject to additional employment tax, along with penalties and interest.
- S corps require stricter controls than sole proprietorships. This means you have to have regular shareholder meetings, minutes have to be recorded for these meetings, and you must follow the corporate bylaws. Perhaps most important, S corp shareholders must be careful about commingling business and personal expenses. Failure to follow these procedures can give a court all the evidence it needs to “pierce the corporate veil” of your business, thereby exposing the members of the S corp to personal liability in the event of a lawsuit.
The C corporation, or C corp, is less common in the small business world than the other entity types. As with S corps, C corp shareholders pay themselves via a salary and distributions. The tax liability for C corps belongs to the business itself, meaning shareholders are only taxed on their salaries and any distributions they receive from the corporation. Since the C corp is taxed on its profits, and then the distribution of those profits is taxed again when the shareholders receive them, C corps get a bad rap for being subject to “double taxation.”
Which Way Is Best?
If you’ve made it this far, congratulations. You now know the many different ways small business owners pay themselves, as well as some of the mechanics behind them.
So, how do you know which way is the best way to pay yourself? Start by consulting with your tax professional. A surprising number of small business owners aren’t sure how their business is organized. You don’t want to assume your business is a disregarded entity only to learn later your tax professional made an S corp election for your business.
Then, consult with your tax professional regularly to ensure your business is still structured in the manner most beneficial to you. As your business and personal situation evolves, you might need to make changes to your business structure to not only minimize taxes but also to ensure you can obtain financing if you need it.
If your business is organized as an S corp, consider outsourcing your payroll to a bookkeeper or accountant, or use a full-service payroll solution, even if you are the only employee in your business. Penalties and interest for missed payroll tax payments add up quickly and can jeopardize your business. Paying for professional help is an investment in your business’ well-being.
Finally, don’t get hung up on the semantics. Whether you receive a salary, a guaranteed payment, or take draws or distributions, the important thing is you have built a business that supports you. This puts you ahead of the unfortunately large number of small business owners who can’t afford to pay themselves.
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