How to Pay Yourself - Business Owner Tax Considerations
How do I pay myself? As a business owner it can be a confusing process. The three primary methods are payroll, guaranteed payments, and owner draws. There are pros and cons to each. Certain business structures require one or the other. There are important tax planning, budgeting, and financial statement implications to each.
Generally sole proprietors, partnerships, and one-member LLC’s are paid exclusively through draws or guaranteed payments. S-Corps must pay owners who participate in the business “reasonable compensation” as defined by the IRS and can take shareholder distributions in addition. Active shareholders of a C-Corp must be on W-2 payroll and accumulated earnings can be distributed as dividends.
If you are an LLC it is important to note that is not a federal tax distinction. Discuss with your tax accountant which of the above structures you have elected to be taxed as.
Always consult your tax accountant before making any changes to your pay structure.
Business owners take a salary by putting themselves on W-2 payroll. Social Security and Medicare payroll taxes are deducted each pay, and the employer portion of payroll taxes are paid by the business.
If this is an option for your business structure, consistency is a benefit. It simplifies the tax administration and makes it easier to budget cash flow.
Owner draws (also called distributions) are simply funds drawn from the business for personal use. This is accomplished either via direct cash withdrawals or personal expenses paid with business accounts. Personal taxes paid with company funds are also owner draws.
Sole proprietors and partners in a partnership pay self-employment taxes on owner draws.
S-corporation shareholder distributions are not subject to self-employment taxes.
A significant benefit of owner draws is the flexibility. It is easier to correlate the draws to net income fluctuations than frequently adjusting payroll.
A partner in a partnership also has a third option called a guaranteed payment. Guaranteed payments are treated as an expense to the partnership, but the member must pay self-employment taxes and make quarterly estimated tax payments. While you are required to pay the full amount of taxes (employee & employer) you may deduct half of it as an expense on the owner's personal return.
Financial Statement Implications
Our role at RTC is to maintain financials, not do taxes, so why are the distinctions important to us? The different methods are accounted for differently on the financial statements.
Wages of owners on payroll and guaranteed payments are captured on the Profit and Loss Statement. It should be allocated to the functions (marketing, admin, service, other) based on the owner’s role.
Draws and distributions are not captured on the Profit and Loss Statement. They are not included in the bottom-line net income. They are reflected in the balance sheet, as an offset against equity. The monthly draw can be calculated by subtracting the prior period from the current period. This is an important consideration when conducting financial analysis and budgeting to reconcile the net income to the true cash flows.
Taxes are extremely complex and there is no way a short article can cover all the different scenarios. Always consult with tax planning professionals to outline the best strategies for you business and help us incorporate them into your forecasting and planning discussions.