Are You Paying Yourself?
Why did you go into business? Was it to just give yourself something to do with your time? Or did you go into business to make money for yourself and your family? If it was to give yourself something to do, you’ve probably just got a hobby. Hopefully you went into business to make money, I know I did. I’m sure there is more to the big WHY behind your business, as there should be if you’re really going to be successful, but the reality is that one of the main goals of your business should be to make a PROFIT. And if you’re making a profit, you need to make sure you’re paying yourself.
Depending on how your business is structured, how exactly you pay yourself will vary. So let’s cover each of the most common entity types and how you get paid.
Sole Proprietor
If you’re operating your business as a sole proprietor, then you and your business are one and the same.
I highly recommend that you have a separate bank account that you use 100% for your business, it makes doing your accounting so much easier. If you have a separate bank account for your business, you should be transferring money to your personal account periodically. Don’t be tempted and just pay for personal things out of your business account, that defeats the purpose of having a separate account!
See blog post – Make Tax Time Less Stressful
If you’re not sure how much you should be taking out of your business as your pay, I highly recommend the book Profit First by Mike Michalowicz. This book recommends splitting any money that comes into your business into buckets – your profit (which should come out first – thus the title), taxes (so you’re setting them aside as you go), and your business operating expenses. You should be paying yourself and setting aside money for taxes first, and using the rest to cover your business expenses. Even if you don’t follow his system exactly, there are some really great concepts that can be implemented in any business.
Limited Liability Company (LLC)
If you’re operating your business as a Limited Liability Company (LLC) and are being taxed as a sole proprietor or a partnership (not an S Corporation – we’ll cover that later), then you will take money out of the business as draws/distributions.
Similar to the sole proprietor, you’ll have a separate business account, although for an LLC it is a requirement to maintain your entity status and liability protection, not just a suggestion. Periodically you will make transfers out of your business account to your personal bank account, on your books these will be classifed as draws or distributions and are not considered an expense of the business. Draws/distributions are reflected in the equity section of the balance sheet.
See the recommendation above to read Profit First by Mike Michalowicz to determine how much you should be taking out of the business.
S Corporation Election
If you’re operating your business as an LLC and have elected to be taxed as an S Corporation, then how you pay yourself gets more complicated, but there can be big tax benefits so it can be worth it.
When you as the owner are the one doing some or all of the work in the business, you are required to pay yourself “reasonable compensation” through payroll as an employee. This means you need to issue yourself an actual paycheck and withhold and pay payroll taxes (federal/state withholding, social security, medicare, state unemployment, etc.). I highly recommend using a payroll service to process the paychecks, withhold and submit payroll taxes, and file required payroll reports. By using a payroll service you ensure you are calculating everything properly and doing the required filings to stay in compliance. Payroll and the related payroll taxes is not something you want to mess around with. I recommend using a service like Gusto, they are a cloud based service and their pricing is reasonable. www.gusto.com
But what is “reasonable compensation”? Unfortunately, there is no easy to follow calculation to determine what is considered reasonable. According to the IRS website, wages paid to you as an officer of a corporation should generally be commensurate with your duties. There is a lot of room to interpret what that means, but if your business is making a profit of $100k, then it would be unlikely that a $15k salary would be considered reasonable by the IRS. You should consider consulting your tax advisor if you need help walking through the process of determining your salary.
In addition to taking a salary through payroll, you can also take money out of your business as draws/distributions. For example, if your business has a profit of $100k, you might pay yourself $50k through payroll, and take the remaining $50k as distributions. The advantage to being able to split the money you take out of your business by being an S corporation is that you can save money on payroll taxes. When you are a sole proprietor, or an LLC taxed as a sole proprietor or partnership, you will pay self-employment taxes on the entire net profit of your business. Self-employment taxes are the equivalent of the employee and employer portions of social security and medicare and work out to be about 15%. When you are taxed as an S corporation and pay yourself through payroll, you pay payroll taxes on your salary, but not on the portion that is take out as draws/distributions. That can add up to big savings when your business is making a sizable profit.
C Corporation
If your business is operating as a C Corporation then, similar to the S Corporation above, you are required to pay yourself a reasonable salary as an owner-employee.
See above discussion of “reasonable compensation.” In addition, you can take money out as dividends/distributions.
One of the main differences tax wise between an S corporation and a C corporation is that in an S corp all of the net profits are passed through to the shareholders for income tax purposes, whereas in a C corp the net profits are taxed at the corporate level, and the shareholders are only taxed on any dividends/distributions.