When payday waves hello, it can make you feel pretty spiffy inside. But if you’re a business owner, that big day can also feel a bit complex. Whether you take an owner’s draw or salary, it’s hard to figure out exactly how much you should dole out to yourself. We’ll explain what goes into that elusive number so you can learn how to pay yourself like a boss (and ahem, as a boss).
How much can I take as an owner’s draw?
As an owner who takes a draw, you can legally take out as much as you want from your equity as long as you’re a sole prop, partner, or an owner of an LLC that’s taxed as a partnership. For partnerships, each partner’s equity is tracked separately, and each partner can draw funds only up to the amount that they own individually.
Now here’s where things get sticky. If your business is an S- or C-corp (or an LLC that gets taxed as one), there are even more details you need to know about. Here we go!
Corporate complexities? Le sigh.
Core to corporations is a smidge of complexity. If your business is a corporation, the IRS keeps a close eye on how much you take as an owner’s draw. Basically, anyone who is both a shareholder and an employee can take a draw if:
- They first receive what the IRS considers to be a “reasonable” salary
- S-corp distributions to more than one shareholder don’t create a second class of stock
Reason with me: What is considered a reasonable salary?
If you have an S-corp, then probably the most relevant IRS regulation for you is that if you’re a shareholder-employee, you must pay yourself a “reasonable” salary. Fine, but what on earth does reasonable mean?
One factor the IRS uses is “the amount that a similar company would pay for the same or similar services.” This only applies if your business has the cash flow to actually afford your salary. On the flip side, you can still work for free or for less than reasonable compensation if you don’t want to pay yourself a distribution. Some folks just who are just starting out might take this route. While the best things in life are free, the best way to reward yourself for all your hard work is (usually) by paying yourself.
Are you an owner who is also an employee at a corporation? Then there’s another wrinkle to watch out for: If the IRS deems your salary to be wildly high, it may treat that excessive salary as a dividend, which your corporation wouldn’t be allowed to take a salary tax deduction on. This situation is most likely to arise within C-corps.
Pop quiz time: Here is the IRS test that determines if pay is reasonable. The final score includes the following answers:
- The duties performed by the employee
- The volume of business handled
- The character and amount of responsibility
- The complexities of your business
- The amount of time required
- The cost of living in the locality
- The ability and achievements of the individual employee performing the service
- The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation
- Your policy regarding pay for all your employees
- The history of pay for each employee
Lots of inputs, right? California CPA Steve Schrepfer, from Blackline Partners, can explain why it’s so complicated:
“The IRS doesn’t want you to get away without paying payroll taxes. So if you have an S-corp and are taking money out of it, they want to see some of it on a W2…. The reverse is true for C-corporations, where the IRS prefers owners to pay themselves through a dividend. If you are making lots of money, and you try to take it all as compensation, the IRS will say that it is over-compensation and is really a dividend. Because a dividend on a C-Corp gets taxed twice.”
At the same time, he says the devil is in the details: “Figuring out what ‘reasonable compensation’ is? It’s up to you to make the argument to the IRS.”
Protecting your S-corp status
Have an S-corp? One more thing to watch out for: You may only take a distribution if your S-corp has one class of stock. So if you have multiple shareholders, and distribution between you gets “disproportionate,” the IRS may see that as a way to give one owner a second class of stock. The IRS could then treat you as a C-corp, which gets taxed twice. If this happens inadvertently and you don’t catch it, you can apply for relief from the IRS, but you may have to jump through hoops to prove it is inadvertent, and there is no guarantee of what the IRS will ultimately decide.
An important caveat: State tax laws and entity classifications can be different from federal ones, so you need to be aware of those as well.
At this point, you should have a more reasonable grasp of what goes into a reasonable salary so you can pull out a number that works for both you and your company. Now, how (unreasonably) cool is that?