As a small business owner, you have a lot of responsibilities. That’s why it’s so important to know how to pay yourself appropriately for all your hard work.
But did you know there are different tax implications for the different ways you can pay yourself? Let’s take a closer look at business owner salaries, dividends, loans, and the owner’s draw to see what your options are when it comes time to run payroll for yourself.
How business structure impacts how you pay yourself
Your business entity matters. You can structure your business as a sole proprietorship, partnership, cooperative, LLC, SMLLC, S Corporation, or C Corporation.
Here’s how each entity works:
The sole proprietorship (aka “sole prop”) is the most basic type of business entity.
All the assets belong to the business owner, but also the liabilities. Because of this, your business is not taxed separately. Instead, your business’s income is your income, and you usually report it with a Schedule C and the standard Form 1040. And don’t forget that you’ll also need to make estimated tax payments quarterly if you expect to make a profit.
Owners of a sole proprietorship pay themselves through an owner’s draw.
If you are in a company with one or more partners, you could consider a business partnership.
Partners in a partnership can pay themselves through an owner’s draw and/or guaranteed payments.
Limited liability company (LLC)
A Limited Liability Company (“LLC”) combines the tax pass-throughs of a partnership and the limited liability protection of a corporation. An LLC may not be taxed as a business entity. Rather, the profits pass through according to the LLC’s operating agreement. The LLC’s active members pay self-employment tax on the income received; passive members do not.
Note that an LLC is a business structure that is covered by state rules. For federal tax purposes, an LLC can be treated as a corporation, partnership, or part of the LLC’s owner’s tax return. You should check with your state, or a tax advisor to make sure you understand how the rules apply to you.
Partners in an LLC can pay themselves through an owner’s draw and/or guaranteed payments.
Single-Member LLC (SMLLC)
A single-member LLC is similar to a sole proprietorship, but with the liability protection (and reporting responsibilities plus fees) of an LLC. Single-member LLCs have one owner and are disregarded entities for tax purposes, meaning that the business’s profits are treated as self-employment income. SMLLC owners fill out a Schedule C, a Form 1040, and pay estimated quarterly taxes—similar to sole proprietors.
SMLLC owners pay themselves through an owner’s draw.
A cooperative is similar to an LLC in that it also provides limited liability and the business may not pay federal taxes. Rather, profits can be passed through to the cooperative’s members (who in turn pay income taxes).
A cooperative is different from any other business entity because of its specific rules for membership and operations. Typically, a cooperative’s members must agree on matters like its bylaws and operations in a democratic fashion.
If you’re looking to incorporate your business but also keep it a pass-through entity, an S corporation gives you that choice. The S corporation is a tax election that can be made by either LLCs or C corps at the federal level.. It’s worth noting that not all states recognize the federal S corp election and you may be required to make a state level S corp election as well.
S corp owners can pay themselves by way of salary and/or dividends.
The last business entity option is the C corp. C corps are less popular amongst small businesses because they are more complicated than the other options and typically have costly administrative fees.
One of the major drawbacks of the C corp is the “double taxation.” A C corp is taxed twice–once on its profits and once on its stockholders’ (i.e., owners) dividends.
C corp owners can pay themselves by way of salary and/or dividends.
Details about how to pay yourself as a small business owner
Now that you know about the different business entities, it’s time to take a look at all the different ways you can pay yourself, depending on your business entity.
|Sole proprietorship||Owner’s draw|
|Sinlg-member LLC||Owner’s draw|
|Partnership||Owner’s draw; guaranteed payments|
|LLCs that are S or C corps||Owner’s draw; guaranteed payments|
|S corp||W2; dividends|
|C corp||W2; dividends|
*Note: Every situation is different! These are generalizations and your situation may be an exception. Consult a financial advisor if you have questions about the best way to pay yourself.
Many business owners choose to become W-2 employees, assuming the business entity is an S corp or C corp—both of which allow an active owner to receive a salary. The W-2 is issued if the employee (aka you, the owner) earns $600 or more in wages or equivalent. W-2 employees are subject to withholding taxes, which are taken out each pay period. A withholding tax is a pay-as-you-go tax to the IRS and can be calculated using the allowances on the W-4 and the IRS withholding calculator.
These three things determine how much should be withheld from your pay:
- Marital status
- Claims (e.g. dependents, deductions, withholdings, etc.) per your W4
- Compensation (Note: This may depend on the state where you are paid.)
Employees who anticipate a full refund may be exempt from withholding. This is different from employees who are exempt, like clergy or certain visa holders. The functionality of having your taxes withheld is one reason why some owners choose to be W-2 employees.
The inverse is also true though. Some business owners who want to pay taxes separately may opt out of W-2 wages. For S corp owners specifically: the IRS may check on a business owner who does not pay themselves a “reasonable compensation” to avoid paying withholding taxes.
How to receive dividends
Business owners can also receive a dividend. Dividends are not taxed if it is a return of capital to the shareholder. Most dividends are paid out in cash, but you can also have a dividend of stock or other assets. Note that you’ll need to fill out a Form 1099-DIV for the IRS, and any applicable state tax forms.
How to take a shareholder loan
It’s not quite “paying yourself,” but some owners may choose to loan themselves money through their business. A shareholder loan must have a stated interest rate, a maturity date, and covenants for non-repayment. (Be sure to have a loan document in place.) There is some risk though. If the loan is below-market, it will be treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction.
How to take an owner’s draw
Finally, a business owner can choose to do an owner’s draw. Unlike W-2 wages, a draw is not taxed at the company level. If you are a sole proprietor or single member LLC owner, you are paid by way of owner’s draw.
It’s also possible to do an owner’s draw as an LLC or even an Scorp. But before you shimmy any funds, check in with your CPA because rules and reporting requirements can vary by state. Also note that distributions should be made according to your specified ownership percentage.
An S corp owner or LLC member can take an owner’s draw as distribution of their equity. The owner’s draw can be made in addition to an owner’s W-2 salary, if that applies.
How to receive guaranteed payments
LLC members and partners in a partnership can’t be paid a salary as employees (the W-2 method), however, they can be paid by way of guaranteed payment. A guaranteed payment is just like it sounds: it’s a guarantee of payment—regardless of whether or not the business makes a profit. The payment is a tax deduction for the business, which should be reported on Form 1065. While a guaranteed payment sounds a lot like a salary, there is a key difference: the recipient of a guaranteed payment may be liable for self-employment taxes and may also need to make estimated tax payments.
Record payments and withdrawals
Be sure to keep your business and personal accounts separate, and when money moves, record it. Specifically: record any payments you make in Gusto (or whatever payroll software you use). Also, record how much you’ve taken out for draws in your owner’s equity account.
Don’t forget about taxes
Once you’ve got a new lump of cash in your personal account, it’s wise to set some of it aside for whatever portion you expect to pay for taxes.
If your business is a pass through entity (which includes partnerships in various forms: general, LLC, S corps—to name a few), you’ll need to include information about distributions in your respective Schedule K-1 (specifically K-1 Form 1065 and K-1 Form 1120-S for an S corp with shareholders) so that you as the owner and anyone else who received an owner’s draw distribution can file and pay taxes properly.
If yours is a sole proprietorship or disregarded entity for tax purposes (like a single-member LLC), all business profits are allocated to you personally and taxed as self-employment income in your Schedule C regardless of what funds you do or don’t take via owner’s draw—but you should still keep detailed records.
Which payment method is best?
Is there a draw method that is most appropriate for a business owner? We asked Carin Weiss-Krolikowski of Kahuna Business Group for her feedback:
“I think the most important thing for any owner of a small business is to have a good bookkeeper and a trusted tax advisor. When paying yourself as a small business owner, many owners think they only have the option for owner’s draw. This, of course, is a viable option. However, if a company is formed as an S corporation, they can pay themselves as a W-2 employee. Same is true with an LLC if they claim to file taxes as an S corporation. There is also the option of Guaranteed Payments (as an LLC) where an owner can pay themselves a salary (no taxes withheld) and take the expense as a line item reducing the company’s annual tax liability. Again, I would urge any business owner to always consult a tax professional.”
However you choose to pay yourself, make sure you’re following all the laws and paying yourself a reasonable amount. Your business (and accountant) will thank you.
Originally published on April 14, 2016.