If you own a small business, you have to juggle a lot of responsibilities and wear many hats. One important and personal decision is how to pay yourself as a business owner. While it may not be the first thing you think about when starting a new company, your compensation is something to consider carefully as you organize the business.
Will you wait for the business to show profits before you take a salary? Or do you want to have an income while your business moves toward profitability?
Small business owners can pay themselves in different ways. The payment method you choose will depend on your needs, the needs of the company, and the tax implications. It’s important to plan ahead to reap the best possible income and tax benefits.
The owner's draw or, simply, draw, is money taken out of the business that the owner can use for personal expenses. It's usually drawn from the owner's equity account. Most small businesses begin with a capital investment from their owners to buy equipment and pay for advertising and other expenses. The capital investment is a loan to the business from which the owner can draw funds, as needed, for repayment.
A draw taken by the owner is a deduction from the business’s capital. Owners and partners can take out any amount of money they choose to reimburse themselves from the business account when they take a draw. There is no payroll tax on the amount they take because they are essentially repaying a loan to themselves.
Salaries are structured differently. If they structure their businesses to pay them a salary, business owners must pay the required payroll taxes. The tax implications can be significant. In addition to payroll taxes incurred by the business, employee-owners will also be subject to income taxes on the salaries they receive. The structure of the business will dictate whether owners can take their income as a draw, a salary with deductions for payroll taxes and/or as dividends.
Dividends are another way small business owners may pay themselves. Dividends can be cash dispersals or can be paid in stocks or other assets. Dividends are not taxed if they are a repayment of capital to the owner of the business. For example, startup costs incurred to get the business rolling and investments later on for equipment are eligible to be reimbursed as non-taxable dividends.
Owners can also take dividend payments as non-repayments on investment. These dividends may be taxable, and business owners should consult with a qualified tax professional to make sure they are reported and taxes are paid correctly.
Many small businesses are one-person operations. More than 86% of businesses that don’t have employees are sole proprietorships. Sole proprietorships are not corporations and are not separated from the assets of the owner; the business and the sole proprietor are treated as a single entity for tax purposes. Any income made through the business is reported on the owner’s personal tax return.
These types of businesses are categorized by the IRS as “pass-through” entities because business profits, losses and deductible business expenses pass through the business to the owners, who pay taxes on their personal income tax returns.
A limited liability company, or LLC, is a business entity that shields the assets of the owner of the business from the liabilities of the company. If an LLC has a single owner (called “member”), it can be run in much the same way as a sole proprietorship, except that there are formalities that must be followed and filing fees that must be paid to set up and maintain the LLC.
Forming an LLC makes the business a separate entity from the owner. If an LLC is sued, for example, the company would incur any losses, and the owner’s personal assets would not be at risk. There is an exception, though, called “piercing the veil,” where the owner of a single-member LLC may, in some situations, lose the liability protection of the LLC.
The rules for forming an LLC vary by state and generally require filing articles of organization.
The IRS treats single-member LLCs as disregarded entities if they are not organized as corporations. This means that for federal income tax purposes, the income and expenses of the LLC pass through to the owner and are reported on the owner’s personal income tax. Although sole practitioners also pass through their business’s income to their personal tax returns, they are not considered disregarded entities—only LLCs are.
By default, single-member LLCs are taxed like sole proprietorships, and multi-member LLCs are taxed like general partnerships. Owners of these LLCs are not considered employees and cannot take salaries. Instead, they must pay themselves by taking owner's draws. However, if the LLC elects to be taxed as a corporation, then a member who works for the business may be an employee and pay themselves a salary.
Keep in mind that LLC rules vary by state, so always check with the state where your LLC is located for the most accurate information.
Whether in a single or multiple-owner LLC, owners may take as many funds (or draws) out of the business as they choose, although taking out too much can cause cash flow problems. Taxes are not deducted from the draws. However, the owners do have to pay quarterly income taxes and, if they work for the business, self-employment tax.
An owner of an LLC can take a salary only if the LLC is taxed as a corporation and the owner actively works for the LLC.
Some business owners prefer to be compensated in the form of a salary to ensure they’ve made their tax and benefits contributions, like FICA for Social Security and Medicare, with every paycheck. Another benefit of taking a salary from your business is that it provides a steady, reportable source of income. If you’re hoping to apply for a mortgage, for example, a reliable, reported income stream can be beneficial for any credit applications.
If owners take a salary, some rules apply. The Internal Revenue Service requires that the amount earned is “reasonable compensation” for the work performed. There are tests business owners can use to determine whether wages are reasonable, but generally, any salary earned should be what a similar business would pay an employee for similar work.
By default, the owner of an LLC cannot be an employee of the business. However, if the LLC chooses to be taxed as a corporation, and the owner actively works for the LLC, then the owner can be an employee and receive a salary.
For tax reasons, LLCs, partnerships and sole proprietorships may elect to become S corporations (S corps) if they meet the IRS requirements and file the required IRS paperwork. Becoming an S corp may lower tax liability by preventing double taxation. Instead of filing a corporate tax return and paying corporate taxes, income and losses flow through to the corporation’s shareholders, who pay the taxes at their individual tax rates.
Shareholders of S corporations and C corporations, and members of LLCs that are organized as S or C corporations, may pay themselves as employees if they work for their companies.
Deciding on the best business structure for your needs and how you will pay yourself as a business owner involves a lot of complex and technical considerations. It's a good idea to consult with an expert financial and/or tax advisor for help in making such decisions.
These advisors understand the big picture and how all the pieces of the financial puzzle fit together. They will help you select the best business entity for your needs, optimize your tax advantages, and stay compliant with the laws and regulations. TriNet's Connect 360 human capital consultants are seasoned professionals, so when you call, you’ll connect with someone who knows the challenges you face. With TriNet, small businesses can receive both personal attention and high-tech services to handle payroll and other HR-related issues.