How to pay yourself as a business owner
There’s no law dictating how to pay yourself as a business owner. It’s 100% up to you how much and when you pay yourself. Your business structure is one factor dictating how to pay yourself from your business.
This article will dive into all of that and more.
We’ll discuss the following:
- How to pay yourself from your business and when you should do it
- The factors like revenue, expenses, and taxes which you should consider
- Tips and strategies you can deploy to leverage your pay and business best
Do this first: Separate personal and business finances
There's one thing you should do before determining how to pay yourself. Separate your business and personal finances. As a business owner, you’ll need to calculate where your income came from to determine your total tax obligation. Trust us; this is much easier when you have a business bank account.
- You can calculate your deductible expenses easier when you separate personal and business expenses. The more deductions you can legally claim, the more you can pay yourself.
- You can better manage personal and business finances. Creating budgets becomes easier as you can automate your bookkeeping.
- You can fully protect yourself from business debt liability. Here's why you want to keep personal and business assets distinct. If you're sued, a judge could disregard your business's liability protection and hold you personally liable.
- You can establish business credit, making it easier to receive loans or government funding in the future.
This advice applies to sole proprietors as well. Is your sole proprietorship at the stage where you’re curious how much to pay yourself? You should file for a DBA to open a business bank account. Alternatively, consider choosing a business structure that offers more personal liability protection.
Let’s discuss how to pay yourself as a business owner based on your business structure.
How to pay yourself as a sole proprietor
You're automatically considered a sole proprietor if you’ve never done anything to set up a specific business structure. Sole proprietors pay themselves by withdrawing cash from their business as profit.
When a sole proprietor has a separate bank account for the business, they’ll take personal withdrawals. These withdrawals are counted as profit and taxed at the year's end. The answer is the same if you mix personal and business finances, but the formula differs. There are no withdrawals. Rather, all sole proprietor profits deposited into your personal account are taxed as profit unless deducted.
How to pay yourself in a partnership
General partnerships are pass-through entities, meaning they "pass-through" profits or losses to partners. A written partnership agreement will usually determine each partner's share of profits and losses.
Partners could take draws as much as they please. However, this could cause complications between partners if the draws are of an unfair amount. This is why creating a clear, written general partnership agreement matters.
What about limited partnerships?
In a limited partnership (LP), one or more partners are general partners while others are limited. The general partner/s assumes full liability and responsibility for the day-to-day operations.
Limited partners, a.k.a silent partners, don’t make decisions regarding the operation or business assets. Limited partners must participate in less than 500 hours in the business in a year. If so, they receive dividends in proportion to their investment. The IRS considers this passive income instead of earned income. This means it’s not subject to FICA or Medicare tax withholdings.
Partnership agreements may also provide guaranteed payments to limited partners. While distributions are not deductible to the business, guaranteed payments are considered a deductible expense. These payments are considered earned income and are subject to self-employment taxes.
How to pay yourself from your LLC
A Limited Liability Company (LLC) is an entity created by state statute. The IRS will assign one of two default tax designations to an LLC, depending on the number of members.
- Single-member LLCs are taxed as sole proprietors
- Multi-member LLCs are taxed as partnerships
Single-member LLCs are LLCs owned by just one owner. Paying yourself as a single-member LLC owner is straightforward. The easiest way is to take “owner draws” from your business profits. This means withdrawing funds from your business bank account and depositing them in personal accounts.
Remember that LLCs pay taxes on all profits, regardless of if you draw those profits to pay yourself. Single-member LLCs report their business income and expenses on Schedule C of the member's personal income tax return.
Legally, LLCs provide owners with liability protection meaning personal assets cannot be seized to pay for debts and financial obligations. However, the IRS considers LLCs “disregarded entities,” meaning the business is not separate from the owner.
Multi-member LLCs are LLCs owned by more than one owner. Single-member LLC owners have 100% control of their business. Multi-member LLCs, the control is divided among the owners. The ownership percentage stated in the operating agreement determines how much each member gets paid.
The most common way for single-member and multi-member LLC owners to pay themselves is through owner draws. Owner draws are also commonly known as “distributions.” Each owner can only take owner draws proportional to their ownership percentage on a pre-agreed-upon schedule.
Guaranteed payments are payments made to an owner/s whether the entity makes a profit or not. Guaranteed payments are essentially the same as a salary, with one difference. The member receiving guaranteed payments is obligated to pay self-employment taxes.
Guaranteed payments are also beneficial to the company they are paid out from, as they can be deducted as a business expense. Guaranteed payments are often used to compensate a specific member for their time, especially if that member is heavily involved in the day-to-day operations.
The last payment option is reserved for LLCs granted an S or C corporation tax status from the IRS. LLC owners switch to this tax status for the tax advantage of not paying self-employment taxes on business income. As a member of an S corp, you have to pay yourself a reasonable salary. This money isn’t subject to FICA payroll tax or self-employment tax.
Here’s the definition of an S corporation according to the IRS:
| “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”
S corporations are restricted to a maximum of 100 owners, who all must be U.S. citizens or residents.
Shareholder-employers are required to receive a reasonable salary. This means the amount similar enterprises would pay for the same or similar services. In exchange, S corporation owners don’t have to pay self-employment taxes on their salary. Even if you’re the only shareholder-employee or general employee, you must set up a payroll system to pay yourself. This is because the wage you pay yourself is subject to payroll taxes, including Medicare, social security, and state and federal taxes.
What about distributions from profits left over?
Here’s the first thing you need to know. Shareholder employees must receive a reasonable salary before receiving and paying non-wage distributions to themselves and other shareholders.
Let’s say your S corporation makes $500,000 in profit, and you pay yourself $150,000 in wages. You would only pay social security and Medicare taxes on your wages. The remaining $350,000 would only be subject to federal and income taxes. If you’re the only member, this is all your money.
Can I keep the money in the business tax-free?
If you ask this question, you’re probably referring to “retained earnings.” Remember, a business that elects to be taxed as an S corp doesn’t have to pay taxes on business profits. That’s not the full answer to your question, however. That’s because all profits and losses pass through to the shareholders. They then report it on their personal income tax return.
The IRS requires all S corporations to allocate losses and profits annually for tax reporting. Failure to do so could result in a loss of subchapter S tax status.
Remember: LLCs and C corporations can be treated as S corporations for tax purposes. A C corporation may make this decision to avoid double taxation. An LLC may make this decision to avoid self-employment taxes.
How do c corp owners get paid?
Here’s the definition of a C corporation:
| A C corporation is a legal entity that exists separately from the people who own, manage, control, and operate it.
Shareholders are divided into three parties:
- Board Of Directors
If you're the only owner of a C corp, you must pay yourself a reasonable salary. A salary of $250,000 is generally considered reasonable for most corporations and $150,000 for personal service corporations. As an employee of your company, you’ll need to set up a payroll system. Your salary will be a deduction to the corporation. You’ll pay your state, federal, and payroll tax.
These same rules apply to C corporations with officers who are separate from shareholders and the board of directors.
Just like S corporations, C corps are owned by shareholders. In other words, earnings and all assets are “owned” by the company. The only difference is that all S corporation owners report all business profit as personal profit.
This isn’t the only way to get money out of your C corporation. It’s important to have an efficient strategy to get money out to maximize tax savings. C corporations are subject to double taxation, meaning the IRS taxes them at the flat 21% federal corporate income tax.
Some corporations make sure that employees' wages cover all taxable business profits. This strategy avoids double taxation.
Let’s look at ways, other than a salary, to get money out of a corporation.
C corporations may distribute money or property to shareholders. These distributions are payments of company profits that corporations make to their shareholders as a reward for holding shares.
Corporate taxable income is taxed once at the corporate level and again at the shareholder level when that income is paid out as dividends. Because of this, owners may not want to receive their compensation as a distribution. This is why the “reasonable compensation” rule exists. If the compensation is excessive, the IRS may reclassify it as dividends to the owner or officer.
Another way to pull money out of your C corporation is through reimbursements. For example, if you spend $25,000 out of pocket on startup costs, you can capture that expense as reimbursement on the corporate books. Once you make that money back, you can reimburse it to yourself at 0% tax. More, since it was an expense for your business, you can write it off as a deduction.
A C corporation can also distribute funds in the form of fringe benefits. Fringe benefits include health care coverage, retirement plans, company cars, tuition assistance, and childcare reimbursements. Fringe benefits are tax-deductible corporate business expenses.
As always, there’s an upper limit to what’s considered acceptable. The IRS may deem excessive fringe benefit distributions as “constructive dividends,” thus taxing them as dividends.
A corporation can lend money to a shareholder as long as it’s well-documented.
A corporation can pay a shareholder rent to use the shareholder’s personal property. The corporation is allowed to take a tax deduction for the rent paid. The shareholder must report the income as rental income on their personal income tax return.
How much should you pay yourself from your business?
Now that you know how to pay yourself, given your business structure, you need to decide how much to pay yourself. That number should factor in the needs of your personal budget and your business budget.
Your business needs could include expenses, downturns, reinvestment, employment taxes, and corporate income tax (if applicable).
As business owners, we’re used to the inconsistency in revenue. Understand that others who rely on your income may not be used to it. This is why calculating a set salary for your business is a good strategy. You can always take an owner draw if your business profit exceeds that salary.
Remember, all profits and losses are passed to your tax return if your business is a pass-through entity. Taking a salary isn’t a strategy to avoid paying income and self-employment taxes. Instead, it’s a budgetary strategy to know how much to pay yourself and how much to reinvest/keep in your business.
Make good financial decisions with ComplYant
As with everything in business, having a plan is a good strategy. Knowing how to pay yourself as a business owner can save you time, stress, and money. Sometimes, you can make strategic tax planning decisions to lower your tax obligation.
If you’re struggling to pay yourself in your business, recognize that your time has value. Too many entrepreneurs work far too long for far too little in the name of “hustle culture”. If that sounds like you, know that ComplYant is here to help you make better financial decisions in your business with our suite of tax tools.