Updated September 2018.
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 salaries, dividends, loans, and the owner’s draw to see what your options are when it comes time to run payroll for yourself.
Your business entity matters
You can structure your business as a sole proprietorship, partnership, cooperative, LLC, S Corporation, or C Corporation.
Here’s how each entity works:
The sole proprietorship 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 you’ll also need to make estimated tax payments quarterly if you expect to make a profit.
If you are in a business with one or more partners, you could consider a partnership. A partnership does not pay income tax at the partnership level; instead, the profits pass through to the partners. A partnership files Form 1065, and Schedule K-1 for the respective partners.
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 to the LLC’s members and they are taxed as personal income.
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.
A cooperative is similar to an LLC in that it is also provides limited liability and may not pay federal taxes. Rather, profits can be passed through to the cooperative’s members. 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. An LLC has an option to file as an S Corp for tax purposes. It’s worth noting that not all states recognize the S Corp distinction from a C Corp.
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.
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.
Many business owners choose to become W-2 employees. 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
- The number of allowances claimed on the W-4
- 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. The IRS may check on a business owner who does not pay themselves a “reasonable compensation” to avoid paying withholding taxes.
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.
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. 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.
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 a partner in a partnership, your income is a draw. However, it’s also possible to do an owner’s draw as an LLC or even an S-Corp.
Therein lies the complications with an owner’s draw. Since draws are not taxed, is there a draw amount that is 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.