Paying Yourself Sounds Like a Dream Come True
Having the opportunity to set your own salary sounds like a dream come true, right? Being self-employed has lots of perks but it also has a whole slew of rules that people who are employed by companies don’t have to follow. One of the big rules is around how self-employed people pay themselves.
Do You Really Have a Salary?
It’s common to hear business owners talk about their salary from their business, but that’s not really how most business owners typically get paid. How small business owners pay themselves out of the business depends on how the company is set up from a legal standpoint. S corps, C corps, sole proprietorships and LLCs, all have different rules governing how their owners, members or shareholders are paid and taxed.
What Type of Business Do You Have?
- Sole Proprietorship
A sole proprietorship is the simplest and cheapest way of starting a business. Sole proprietors have complete control over the company, including taking money out of the business account. But with great power comes great responsibility. In a sole proprietorship, there’s no legal distinction between the owner and the business. This means that the owner is responsible for all liabilities and legal actions taken against the business.
In a partnership, two or more business owners share in the profits and losses of the business as determined by a formal partnership agreement. This agreement also details other important features of the business relationship, including when the partners can take money out of the business.
- Limited liability company (LLC)
An LLC is a sort of hybrid between a partnership and a full-fledged corporation, and it can be owned by a single person or partners. This type of business structure provides reduced personal liability for the owners, as well as a little more leeway than a corporation when it comes to choosing the most advantageous tax treatment. An LLC is taxed either as a partnership or a sole proprietorship unless the members (owners) agree to be taxed as an S or C corporation.
- S Corporation
An S corp is a business structure is similar to a C corporation with a few important distinctions:
- It must have fewer than 100 shareholders
- The business is not taxed. Instead, shareholders pay income tax on the profits and losses that pass through to their personal tax returns.
- When a shareholder takes money out of the business, it’s not a salary or draw. It’s called a distribution, which is not subject to payroll taxes. But any shareholder who is also employed by the corporation must pay themselves a reasonable salary before taking a distribution.
- C corporation
A C corp can have an unrestricted number of shareholders. In order to maintain transparency with shareholders, they’re responsible for keeping very detailed records and reporting. The IRS also treats them very differently when it comes to taxes. Unlike S corps, C corps are subject to corporate income tax. And when a shareholder gets income or dividends, they’re personally taxed.
Draw vs. Distribution vs. Salary
When most businesses start, it’s common to see owners paying themselves out of the main bank account for the business. As the business matures, however, it’s important to ensure that there’s some structure in the way the owner is paid. Depending on how the business is structured, there are also laws to follow to keep you out of the IRS’s spotlight. This handy chart can help break down the types of payment.
|Payment Type||Who does it apply to?||Where is it in the financials?|
|Draw||Sole proprietors||Balance sheet|
|Salary||S corps and C corps||P&L statement|
|Distribution||Partnerships, S corps and C corps||Balance sheet|
A couple of things to keep in mind:
- If you’re a sole proprietor, you must pay self-employment taxes on the income you make from your business. When you’re employed by someone else, FICA taxes like Social Security are taken out for you.
- When you’re in a partnership, you have to file a Form K-1 with your taxes, which details all partners’ shares of the partnership’s earnings, losses, deductions and credits.
How Much Should You Pay Yourself?
There’s no real set answer to this question. Deciding how much to pay yourself should be based on how much money your business needs to operate. You also need to consider your tax situation before making the choice.
How Do Self-Employment Taxes Work for Business Owners?
If your company is formed as a sole proprietorship, a partnership or an LLC, you’ll likely still be responsible for paying self-employment taxes. These taxes are levied on your net self-employment income, which is your business income minus any deductions.
The total self-employment tax is 15.3% of your net earnings, and it’s made up of two parts: Social Security at 12.4% and Medicare at 2.9%. You’re required to make quarterly payments to the IRS for these taxes. If you don’t, you might get a nasty surprise come tax time as you’ll have to pay the entire amount of taxes owed plus any fines and penalties.
How Paycor Helps
If all of these calculations and decision-making sound overwhelming, you’re right! It’s tough going it alone. In addition to your CPA and attorney, you should also partner with a payroll and HR company that can be by your side and grow with you as your business does. Contact Paycor and see how we can help.