Ways to Pay Yourself from Your Business
You started your own business so you could work for yourself, do something you love, and earn what you deserve. But, paying yourself out of your business can sometimes feel like a luxury, especially in the early years. Starting a business doesn’t have to be all about struggle. Instead, create a sustainable plan to pay yourself that supports you and allows your business to grow.
Entity Status Impacts How You Earn
Like many other aspects of running a business, how you pay yourself is heavily impacted by your company’s entity structure. Sole proprietorships, LLCs, and C-Corporations are all treated differently, and their owners are all taxed differently.
First, let’s do a quick rundown of the different business structures and how owners can pay themselves.
In a sole proprietorship, all business assets belong to the owner, as do the liabilities. Therefore, a sole proprietor is free to pay herself whatever and whenever she likes. All business revenue is treated as direct income to the owner. Because there is no company taking taxes out on your behalf, you will need to set taxes aside out of your business revenue and pay estimated taxes throughout the year.
As we have discussed in other blog posts, LLCs are very flexible. A single member LLC, for example, can be treated as a “pass-through” entity and taxed just like a sole proprietorship above. However, LLCs can also elect to be taxed as corporations, described below.
When paying yourself as the owner of an LLC, you basically have two ways to get paid, and there are pros and cons to each: earn wages as an employee and/or receive distributions from LLC profits.
Earn Wages as a W2 Employee
If you choose to earn wages as an employee, you would treat yourself as any other of your W-2 employees. This allows you to receive regular, predictable compensation and deduct your salary from the LLC’s profits. However, you can only give yourself a salary if (1) you are actively working in the business and (2) your compensation is considered “reasonable” by the IRS. The IRS does not allow deductions of salaries that are not reasonable. Reasonableness is determined by the kind of work you perform, how many hours you work, your experience level, and the industry standard for an employee performing your duties.
As an employee, the business will withhold payroll taxes on the income you receive. That means that you do not need to set aside a portion of your W2 earnings to pay estimated taxes.
If your business is doing well and there are excess profits that you want to utilize, you can still do so. However, you will use the “owner draw” method to take additional payments, rather than increase your salary.
Take Distributions as an Owner Draw
Instead of, or in addition to, a salary, you may choose to receive distributions of the profits from your LLC. Based on your percentage ownership of the LLC, you can take up to that percent of the total profits for the year. For example, if two business partners own an LLC in equal shares (each own 50%), each can take distributions from the profits throughout the year, totalling up to 50% of the LLC’s total annual profits. For a single member LLC, the owner can take up to 100%.
Because owner draws are not taxed before distribution, it is the owner’s responsibility to set aside a percentage of their distributions to be paid as estimated taxes. Regardless of how much of the business profit owner(s) choose to take as distributions, owners are taxed on the full profits of the business. So, even if a sole LLC owner only takes 10% of profits as an owners draw, he will still be responsible to pay taxes on the full amount of the profits.
In general, C-Corporations are more complicated and less flexible than LLCs, so they are not as popular for small businesses. However, it is also possible to own a C-Corporation and pay yourself out of the business. C-Corps are distinct legal entities for the purpose of taxation. This creates what is sometimes called “double taxation.” Unlike the “pass-through” taxation described above (when the business revenue is treated as income to the owner and is taxed directly at the owner’s tax rate), C-Corps pay taxes on their revenue as it comes into the business and then owners pay taxes again on the income they take from the business.
Owners of a C-Corp can earn money from their business in two ways: salary or dividends. Unlike an LLC or Sole Proprietorship, a corporation owner cannot simply take distributions out of the company profits whenever he chooses.
Earn Wages as a W2 Employee
As with an LLC, a corporation owner may choose to pay herself a salary. However, she can only do so if she actually works for the corporation and if the salary constitutes “reasonable compensation.” Just like any other W2 employee, a corporate owner who receives a salary is on payroll, receives wages on a regular basis, and has taxes withheld before being paid.
Take Distributions as a Shareholder
Unlike a salary, dividends are paid each year only if the shareholders decide to do so. Many new companies do not pay dividends and instead put the profits back into the business. If shareholders (including the owner of the corporation) do receive dividends, they include this income on their personal tax returns.
Paying Estimated Taxes Throughout the Year
If you choose to pay yourself out of the business through owner draws or dividends, it is important to remember that your company is not withholding and paying payroll taxes on your behalf. However, these taxes are still owed on your earned income (or in the case of a pass-through entity on the company’s total profits). It is highly recommended to plan throughout the year to pay your taxes. There are online programs that you can use, along with consultation with your CPA, to ensure that you are setting aside enough money for your taxes and paying estimated taxes throughout the year.
Determining How Much to Pay Yourself
The number one rule in determining your salary is: Don’t Undervalue Yourself. Even if your business doesn’t turn a profit the first year, that doesn’t mean you shouldn’t be earning a live-able salary. Undervaluing your own time can cause stress and resentment, both of which can damage your business’ productivity and growth. At the least, make sure you are paying yourself enough that you aren’t worried about personal finances while running your business.
Most business owners do not approach this decision with a specific number in mind. Instead, they work through their finances by subtracting taxes, payroll, fixed costs, and overhead from business revenue. Out of what remains, they determine an appropriate salary.
If you do find yourself with some extra profit and you want to earn more, great! Consult with your CPA to determine how best to utilize owners draws, salary, and dividends to increase your income.
Work with an Experienced Advisor to Structure Your Business to Support You
At Enterprise Esquire, we advise our business clients throughout the lifecycle of a company. Before even choosing an entity structure, it is a good idea to consider how and when you want to pay yourself. This information can factor into your decision making. Our experienced attorney can walk you through this process to ensure you make an informed decision. If you have already chosen a business structure and have been operating your business without understanding how to properly pay yourself, let’s talk! We can also provide guidance with regard to business operations and paying yourself legally. Click here to set up a FREE 15-minute consultation. We look forward to hearing from you!