Wondering how you should pay yourself? Well, with IRS requirements, sometimes it can be confusing on how to actually give yourself your hard earned money. We have everything you need to know on the differences between taking a salary, guaranteed payment and distribution and when one or the other is mandated by the IRS.
Understanding Your Business Entity
Single member or married filing joint LLC is a disregarded entity in the eyes of the IRS and this means you’re a schedule C – tax filer and you’re being taxed on the Net Income of the business which is 100% subject to Self-employment tax. Payroll is not required and distributions from the business are how you will get paid.
Partnership with more than one member – depending on your involvement and operating agreement you may be subject to guaranteed payments – which is subject to Self-employment tax while additional profits may be treated as a distribution taxable as ordinary business income. No payroll is required here, but you as the individual member will be responsible for paying the payroll taxes as both the employer and employee if the monies received are subject to self-employment tax. This means if you are a member of a partnership receiving taxable income from a K1 you most likely should be making estimated tax payments, to avoid a huge tax bill at tax time.
S-corp shareholders actively participating in the business are required to take a reasonable payroll via W2 per the IRS. Shareholders may also take distributions out of the business which are not subject to payroll taxes throughout the year but this should only happen after taking a reasonable salary via W2 first.
C-Corp shareholders actively participating in the business are required to take a reasonable payroll via W2 per the IRS. Any distributions outside of payroll would be treated as a dividend.
Paying Yourself a Salary
If you decide to pay yourself a salary from your business, you are a W2 employee just like any other person you hire. Your company withholds your taxes and pre-tax benefit contributions for you and contributes their portion of employer payroll taxes too. As a W2 employee, you as the shareholder must take a “reasonable compensation” amount, or you can get flagged by the IRS. Basically, the IRS wants to make sure you’re not paying yourself so little that you avoid payroll taxes.
The Pros of Paying Yourself a Salary Are:
● Steady income stream – you know what you’re getting each pay period and showing a steady income can help with things like loans and mortgages.
● Less admin work, you set it up and it’s good to go each pay period.
● Your taxes are already pulled out each time you get paid, so you don’t have to worry about a giant tax bill at the end of the year.
● Paying yourself the same amount every month can help you better understand your business’s capital, plan for upcoming expenses, manage cash flow and track expenses.
● It requires you to actually pay yourself! All too often business owners let their businesses become a money eating monster, paying everyone but themselves.
The Cons of Paying Yourself a Salary Are:
● Determining reasonable compensation can be hard. It must pay your bills while keeping sufficient cash flow in the business for operational needs. If your compensation falls outside the “reasonable” range, it could raise flags with the IRS.
If you decide to go the salary route, you’ll want to make sure you talk with your tax strategist for help determining reasonable compensation.
Giving Yourself an Owner’s Distribution
An alternative to giving yourself a regular salary is to take out an owner’s distribution. In simple terms, an owner’s distribution is you withdrawing money from your business.
However, owners can’t simply draw as much as they want; they can only draw as much as their owner’s equity allows. Meet with your tax advisor throughout the year to help you decide how much of a draw you can legally take.
Owner’s draws are also limited to sole proprietors, partnerships, and certain LLCs. If you are an S-Corp or C-Corp, it gets more tricky and you want to meet with your tax advisor to see if a draw is right for you.
The Pros of Taking an Owner’s Distribution:
● You can pay yourself without having to set up expensive and time consuming payroll processes.
● May not be subject to self-employment tax equally roughly a 7.5% tax savings
● Helps with cash flow since no other taxes are required to be paid at this time.
The Cons of Taking an Owner’s Distribution:
● You delay the inevitable by paying self-employment taxes, Social Security and Medicare taxes, and ordinary income tax all at one time.
● Depending on your business entity, you could potentially pay double taxes.
Guaranteed payment – which is an IRS term is defined as a payment to a partner or member (in a LLC) for service rendered without regard to income. This acts like salary in that it becomes an expense of the company.
The Pros of Taking an GP:
● This is a fixed amount that you can budget for
● No need for payroll service or payroll taxes
The Cons of Taking an GP:
● Payroll tax liability is due on the individual partner or member’s personal return.
● Businesses are required to pay GP regardless of available income.
So, what’s the best way to pay yourself as a business owner? The answer is it just depends on your personal circumstances, so talk with your tax strategist to help you get paid the right way.