Did you know that how you pay yourself in your business depends on your business entity and tax structure? Being an entrepreneur can be a learning curve. So many things to remember and so important you pay yourself correctly.
In this blog we will look at paying yourself from these entity structures:
The Sole Proprietorship is the easiest and basic of all entities to form. This makes it one of the most popular entities for small businesses. As a Sole Proprietor you and your business are considered the same entity. You are the only owner and responsible for all of your business assets and liabilities.
As Sole Proprietorship you are compensated by taking an owner’s draw from the business. The owner’s draw can be taken at any time and for any amount of money. It would be advisable not to take all income so that expenses can be paid when due.
Taxes aren’t taken out of an owner’s draw as it would if you were an employee and earning a salary. You will need to pay self-employment taxes and estimated quarterly taxes on your income.
To file taxes you will use schedule C to form 1040 along with your federal tax return.
Partnerships are formed when there are two are more people owning the business. As with the Sole Proprietorship, Partnerships aren’t taxed as an entity either. Profit and losses are passed down through to the partners. Partners are the same legal entity as their business.
To compensate yourself in a Partnership you will need to take an owner’s draw, sometimes called an owner’s distribution. These funds aren’t taxed. You will need to pay self-employment taxes along with quarterly estimated taxes.
To file taxes the business will file a federal 1065 and K-1’s to the respective partners. You as a partner will file the K-1 along with your federal 1040. The K-1 shows the partners share of:
Limited Liability Company (LLC)
LLC’s can choose how they would like to be taxed as an entity:
Single member LLC’s are treated like Sole Proprietorships
Multi member LLC’s are treated like Partnerships
Either Single or Multi member LLC’s can choose to be treated as a corporation
Single and Multi member LLC’s are compensated with an owner’s draw. Just like Sole Proprietors and Partnerships, they aren’t taxed on the compensation and will need to pay both self employment taxes and quarterly estimated taxes.
Single member will file a schedule C with their 1040 tax return. Multi member will receive a K-1 to file along with their 1040. The multi member business entity will file the 1065 tax return and produces the K-1 for the partners.
The LLC’s that choose to be treated as a corporation will take a salary. Read further along as I discuss the Corporation in more detail.
The owners of an S-Corporation are separate from the business. S-Corporations pay their own income tax by filing form 1120S. The S-Corporations aren’t double taxed like the C-Corporation that will be discussed in the next section.
To compensate yourself, an S-Corporation can receive both:
The salary will be taxed unlike the owner’s draw or distribution. There is also one other way and S-Corporation can be paid.They can be paid by dividends. If there is more than one owner or shareholder then the dividends can’t be taken as freely.
One item to note: The Internal Revenue Service expects you to take a reasonable salary according to your job description. Paying yourself too little or too much are both red flags and the IRS might just investigate the business.
Some ways to determine reasonable compensation are:
Pay compared to other employees in the business
Your time and effort invested in the business
Compare salaries to other individuals in your industry
Is your pay directly related to the hours you work
What duties are your performing as part of your role in the business
What is your level of responsibility in the business
Lastly, the C-Corporations. This entity is probably one of the least favorite with small business. Several reasons are:
Just like S-Corporations, C-Corporations file and pay their own taxes. But in the case of C-Corporations, they file tax form 1120. The taxes aren’t passed through to the owner.
To compensate yourself with a C-Corporation you will receive a salary that will have taxes withheld out just like a normal employee. You may also receive dividends, but you will not take an owner’s draw. If you don’t actively work in the C-Corporation, you will receive dividends.
As with the S-Corps, you need to have a reasonable salary. You will receive a W-2 in order to file your tax return.
It is very important that you understand your business entity so that you are being paid correctly according to the tax structure of your business.
Don’t forget to pay the self employment taxes and quarterly estimated taxes if you are:
For the Corporations you will need to pay the payroll taxes due that have withheld from your employees paychecks.
Above all else, pay attention to your cash flow and your profit & loss as you decide how much to pay yourself.
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