If you're like most people starting a small business, the question of how to pay yourself as a business owner has confused you more than once. Maybe you've been working through your savings and your business is just at the place where it can afford your salary. (Yay! Congrats!) Or maybe you're just getting ready to set up your business through the state and you have no idea what type of business model to choose. Well, if you’re wrestling with these questions, you are not alone!
Today, we are going to do a broad overview of the four options for how to pay yourself as a business owner and why you may choose them based on the type of business entity you have. Keep in mind, this is not an in-depth article. I would highly encourage business owners and entrepreneurs who are just starting out to seek advice from their tax or bookkeeping expert. They can look at all the angles of your business and give you the best advice.
Here today, I want to give you a basic understanding so you can either rest-assured the way you're paying yourself is within the trend for businesses such as yours OR spur you on to go ask further questions.
As we have been talking about being year-end ready and audit proof, this is a great subject to address! Having your salary and draws in order is one more potential red-flag item for the IRS for you to check off of the list.
If your business is set up as an LLC, sole proprietorship or partnership, the IRS considers you and the business as one entity. This means any profit the business makes, is your profit in the eyes of the IRS. The total of the business’ profits is what you will be paying taxes on, not just what you choose to draw from the company throughout the year.
Because of this, you can “draw” money from your profits whenever you choose. You may, like many small business owners, have made a capital investment into your company during its start up phase. Your draw can either be considered a return of investment OR a draw on the profits of the company. But since you and the company are one, both would affect the equity of the company, not the profits and losses. Neither are taxed at the time of the draw.
This is important to note. While your draw isn’t taxed at the time of payment, you will be expected to pay taxes on the total profits for the company, come tax time. Depending on how high your company's profits are throughout the year, the IRS may require you to make estimated payments on your predicted taxes each quarter.
Even if this is not required, it’s wise for every small business owner to either opt in to these estimated payments or set up a savings account for this purpose.
New to the role of running a small business? Then don't miss 5 Ways for New Business Owners to Take Financial Control.
Owners who are involved in the day to day operations of their business can choose to take a salary.
For example, a restaurant owner may have set up their business as an LLC but then hired a chef and a manager to run the day to day operations. That owner would be able to pay himself in draws, as mentioned above. If however the owner of the restaurant was also the chef or the house manager, they could choose to pay themselves a salary. (This is not an option for partnerships. But more on that later.)
This salary would affect the profit and loss of the company. It would also change the amount of profit the company would be taxed on at the end of the year. However, as an LLC (or any other non-incorporated entity) this owner would still be required to pay taxes. And these taxes will be on both the salary they choose to take as well as the overall profit of the company.
(Learn more about bookkeeping for restaurants here)
Here’s a simple breakdown. A company profits = $50,000, the owner pays taxes on $50,000. OR Owner takes a $20,000 salary so the company profits = $30,000. The owner pays taxes on $50,000, $20,000 through a W2 and $30,000 through business profits.
So far, we have only talked about payments for non-incorporated businesses.
For those running an S-Corp or a C-Corp, the rules are a little different. With both, they are seen as separate entities. This means either the shareholders (as with S-Corps) or the company (as with C-Corps) hold the tax responsibility. With both types, there is an option for salary as well as distributions of profit shares.
Here, there is one important thing to note that differs from the salaries for non-incorporated entities. The IRS expects any shareholders/owners who are involved in the day to day operations to take a reasonable salary. This again means it will be taxed upon payment and it will reduce the profit of the company.
The IRS keeps a watchful eye on both of these types of entities. They also look especially close at the amount of wages being paid. If you're not paying yourself a reasonable salary and are instead choosing to take a large draw through distributions, which are taxed at a lesser rate? This is a major red flag for the IRS.
(To learn about the five financial business reports every business should read, visit this post next)
Remember I said those in a partnership did not have the option to take a salary?
The guaranteed payment is basically the partnership version of a salary. In a partnership, both profits and tax liability are split in a partnership agreement. If the partnership is 50/50 split and a company’s profits were $50,000, each partner would be responsible for tax on $25,000 as well as have access to those $25,000 in profit.
Here is the twist though...
As part of the agreement, a partner can be paid a guaranteed payment for work invested into the company. This is separate from the profit share and actually affects the profit and loss, just as a salary would. The partner receiving the guaranteed payment would pay self-employment taxes on that payment as well as taxes on their share of the business profits. But remember, this payment is reducing the total profit of the company.
So say the partnership mentioned above has also agreed for partner 1 to take $10,000 in guaranteed payments. This would then reduce the profits to $40,000. Partner 1 would pay self-employment taxes on the $10,000 and be responsible for the taxes on $20,000 of business profits. Whereas partner 2 would only be responsible for the tax on $20,000 in business profits.
(Read these eight tax reduction tips for small businesses next)
While that was considered a broad overview, it is still a lot to take in! And if you are in the position of getting ready to establish your business? Then you may be wondering how in the heck you choose between these types.
Again, I encourage you to speak with a CPA about your business particulars. But here is the biggest question you need to consider:
With either of the incorporated options, since salaries are required, this means your operating budget will be reduced by that amount.
Let's say you're just starting up and have limited or unpredictable cash on hand. Then, you may feel more comfortable choosing a non-incorporated option where you can take a draw when needed but are not required to. This can ensure you have cash available to pay your bills and other liabilities as you get off the ground.
You can always restructure your business as it grows, if the changes mean another way would be more beneficial tax-wise.
Most of all and especially with incorporated businesses, I would highly recommend outsourcing your payroll to a bookkeeper or professional service. Even if you are the only employee of the business, making mistakes or missing tax liabilities with these could end up costing your personal and business finances in huge ways with IRS penalties.
Owning a small business is stressful enough. But making sure you have structured your business and your pay correctly doesn't need to be stressful!
As you learn about the different options, pursue further conversation with your CPA, and then make confident and informed decisions, you can breathe easy knowing you are operating with accuracy AND give yourself a giant pat on the back for being boss and earning your pay through your hard work and brilliant business contributions.
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Here are three more posts to read next:
Restaurant Outsourcing: Get (and Keep) Your Financials on Track
3 Things You Absolutely Need To Consider When Hiring A Bookkeeper
This post was first published in 2020, but it was updated in 2022 just for you.