How to Pay Yourself from an S Corp, LLC or Other Small Business
If you’re self-employed, there can be a lot confusion around the optimal way to pay yourself from your business entity. If you pay yourself, some natural questions arise. Are you still considered to be an employee? Should you take a salary or is there a better way to pay yourself? How is all this money taxed? These are all good questions and ones we’re happy to answer for you.
Salary, Owner’s Draw and Dividends
You don’t want to work for free, so it’s imperative to understand how to pay yourself as a business owner. The first way is through a salary. The salary method typically works best for businesses structured as S corporations or C corporations. Under this payment method, the payroll for self employed workers looks exactly the same as it does for any other employees. Each week you or your payroll service will cut you a paycheck, deducting the appropriate payroll taxes as you normally would and providing a W-2 at the end of the tax year.
Another possible payment method for business owners is the owner’s draw. The draw is an acceptable payment method in sole proprietorships and partnerships. Put quite simply, a draw is an amount of money you take out of the business whenever you want and in (almost) any amount you want.
Here’s why this works: sole proprietorships and partnerships are pass-through entities. At the end of the year, the owners are personally taxed on any profits the business made because all of that money belongs to the owners. Corporations create separate entities, but pass-through entities don’t. All the money is yours and you can have it whenever you want. Note that you cannot take a draw from an S corporation, even if you are an owner.
There are two important caveats here to keep in mind, however. The first is that any money you pull from your business is no longer available to the business. You’ll want to make sure you leave your business with enough money to pay bills and expand so it can grow.
The second caveat has to do with partnerships. In a partnership, multiple partners contribute to the business and own parts of it. Every time you contribute cash, equipment, expertise or other items to the business, you increase your equity in it. You must be careful when taking a draw, however, since your draw cannot exceed your total owner’s equity.
If you’re the owner of an S corporation, the IRS considers you a shareholder employee. Like other shareholders, you are entitled to dividends or distributions your company pays on its stock. This is good news, since as an S corporation shareholder employee you can receive both an s corp salary and dividends, in essence creating two avenues of income for yourself.
Special S Corporation Salary Rules
Potential Tax Savings
S Corporations are popular among small business owners, and the tax advantages are a big reason why. As the owner of an S Corporation, you will – like many entrepreneurs – have to pay self-employment tax on any salary you take from your business. But here is the good news — you don’t have to pay self-employment tax on any dividends you pay yourself. This means that a chunk of the compensation you receive during the year can be had without the burden of self-employment tax, adding up to considerable savings come tax time.
The Reasonable Salary Rule
Before you pop the cork on that champagne and celebrate your reduced self-employment tax burden, be aware that there are some rules. The IRS will let you skip out on some of your self-employment taxes, but it’s not about to let you off the hook altogether. The reasonable compensation rule requires S corp owners to pay themselves a reasonable salary.
What’s reasonable? That depends. When determining a fair salary, you’ll want to consider what you would make if you were doing the same work for someone else in your area. Take into account your training, experience, and education. If you have employees, think about what you pay them as well. As the business owner, it probably wouldn’t make much sense for you to be making the same amount as your receptionist.
The S Corp Salary 60 40 Rule
Technically this isn’t a hard and fast rule. In fact, the 60 40 rule is not officially implemented or recognized by the IRS. However, CPAs and other tax professionals have used the S Corp salary 60 40 rule for years.
According to this guideline, you’re unlikely to run afoul of the IRS if 60 percent of your income for the year is classified as salary and the other 40 percent dividends. You can adjust this formula and/or your salary without fear of retribution if your business is clearly making very little money. Once things pick up and start to turn around, however, make sure you’re using this rule or another suitable formula to calculate your salary and have data to support the salary you choose if asked.
Tax Withholding Information
No matter what type of payment you opt to receive, it’s imperative that you understand the way tax withholding works — or doesn’t. When you receive a salary from an S corporation, the payroll taxes would be withheld from you just as they would be if you worked elsewhere.
This is not the case, however, with draws and dividends. Taxes are not withheld on these payments, so you’ll have to pay tax on them at the end of the year or, if you expect to owe a lot, make estimated tax payments throughout the year. It’s very important to be aware of when taxes are withheld and when they aren’t as it can make a massive difference come tax time. If you’re taking a salary but still expect a nice chunk of dividends or anticipate taking a draw, consider upping the deductions from your weekly salary to help reduce the amount of tax you will owe come April 15.
Tax Forms to Fill Out
As a business owner, you’ll need to report salaries, draws and dividend payments to the IRS and the people who received these payments. As a taxpayer, you’ll also have to report these forms of income on your personal income tax return. This can all add up to a lot of paperwork, so here we’ll break down which forms you need based on the type of business entity you’re operating.
As mentioned previously, single-member LLCs are pass-through entities, so all of their income belongs to you at tax time. As a sole proprietor, it’s your job to track your income and expenses throughout the year. If you performed more than $600 worth of work for a particular client, they should send you a Form 1099 detailing the payments you received from them. Otherwise, you’re on your own. Thank goodness you keep such meticulous records.
At the end of the year, you’ll gather your 1099 forms as well as your own records and report your income (or loss) on a Schedule C. The Schedule C will ask you to record your income and expenses, tally the lot and then tell you exactly what to record on your Form 1040 tax return.
Multi-member LLCs or Partnerships
Like sole proprietorships, the owners of partnerships or multi-member LLCs are legally responsible for paying the business’ taxes. Things get a little more complicated here, however. The partnership itself isn’t required to pay any tax, but it is required to file an information return with the IRS. This return, a Form 1065, details the income and expense of the business to determine a profit or loss. Attached to this form is a Schedule K-1 for each business partner, detailing that person’s portion of the tax responsibility. Each partner also gets a copy of the appropriate Schedule K-1.
After receiving a schedule K-1, you will fill out and file a Schedule E. This supplemental profit and loss schedule will ask for information related to your business and certain other activities, if applicable. The instructions will then tell you what to report where on your Form 1040.
S Corporations require their own paperwork as well. Remember that you are required to take a salary from your S Corporation. As such, your business will have to report payroll information to each employee on a Form W-2. It will also have to file a Form W-3 with the Social Security Administration. Additional payroll tax returns may be due to your state and local governments.
The S Corporation must also file a Form 1120-S with the IRS. This return is similar to the one filed by partnerships and as such is accompanied by a Schedule K-1S for every shareholder. The Schedule K-1S details how much of the company’s profit or loss belongs to each shareholder.
Hang on because we’re not quite done yet. The S Corporation must also prepare and file Form 1099-DIV reports. Sent to the IRS as well as each shareholder, this form reports any dividend distributions paid to stockholders.
As an employee and taxpayer, you will receive a W-2, a Schedule K-1S and possibly a Form 1099-DIV from your business. The information on your W-2 is reported as wages on your Form 1040 as usual. Report the information on your Schedule K-1S on a Form 1040 Schedule E and treat the dividends reported on your Form 1099-DIV as capital gains reported on a Schedule D.
C corporations too have paperwork to file, but things work a little differently for this business structure. Every year, C corps must file a Form 1120 tax return. The corporation itself is responsible for any tax due on corporate income, however, rather than the business owner or shareholders. The corporation must also prepare Forms W-2 and 1099-DIV for both the IRS and any individuals who received wages and/or dividends.
If you worked for a C corporation, your tax documents from the company are likely to be simple. If you were an employee, you should get a Form W-2 to report your wages on Form 1040. If you received dividends, you will get a Form 1099-DIV so you can report your dividends or capital gains. If you are an independent contractor (sole proprietor) who did more than $600 worth of work for the company, you should receive a Form 1099-MISC or 1099-NEC which you will use to complete a Schedule C.
As you can see, knowing how to pay yourself as a business owner can be tough. Owning your own business is extremely rewarding, but it can clearly generate a lot of tax choices and paperwork. At Picnic Tax, we’re here to help you navigate both. We can help you decide what type of payments will work best for you and help you get through all of the necessary reporting requirements for both you and your business.
Whether you’re new to all of this or are a seasoned pro who just has a quick question about your current tax filing, we’re happy to get you over the hump so you can get back to focusing on your core business.