Paying You: How to Pay Yourself When You’re the Business Owner

Freelance consultants and business owners dedicate a considerable chunk of mental bandwidth to thinking about how to generate business, because the top line matters. We think a lot about making money, but we may not devote much time to thinking through the mechanics of paying ourselves once the money arrives.

Sole Proprietors and single person LLC owners may consider the self-payment process a no-brainer—as invoices are paid, one simply deposits the money into the business bank account. But like so may actions that seem easy at first glance there is usually a right way, a smart way, to pay oneself as a self-employed person.

So—are you on your business’ payroll or do you take payments from your business in the form of owner draws? Do you and your business partners take guaranteed payments (salary)?  Are you paying yourself too much or not enough? How can you tell? Also, where in your business financials are the payments recorded?

Business type Payment Tax return Payroll Tax

Sole Proprietor Owner’s draw         1040/ Sched. C     Yes                                

Single LLC Member draw 1040/ Sched. C Yes

Multi LLC Member share 1040/ Sched. K-1 Yes

S Corporation Dividend/ wage 1040/ Sched. K-1 Yes

C Corporation Dividends 1040 dividends not on dividends

Sole Proprietor

Business owners and Freelancers who adopt this, the default business structure, pay themselves through an owner’s draw, i.e., the amount of money taken from business earnings, after expenses and taxes, by the owner for his/her personal use. The payment is called a draw because money is drawn out of the business.

Sole Proprietors usually take draws by writing a check to themselves from their business bank accounts. Smart Sole Proprietors will then deposit that check into a personal bank account and avoid co-mingling business and personal funds, a practice that inevitably leads to accounting and tax complications. The owner’s draw doesn’t affect business taxes because the net income has already been taxed. The draw is also not a business expense. From an accounting and tax perspective, the owner’s draw is income distribution. Owner draws are recorded on the Balance Sheet.

Limited Liability Company (LLC)

LLC owners, who are known as members, are not (always) considered employees of the entity and therefore they do not (always) take a salary as would an employee. LLC members, especially single member entities, usually pay themselves with a member’s draw, which is taken from the member’s capital account (business bank account). Multiple owner LLCs are considered to be partners in the business and pay themselves with a member’s share distribution, also taken from the member’s capital account. 

While members may periodically draw from their capital account, a draw is in reality an early withdrawal of anticipated year-end profits, a goal that is perhaps at top-of-mind at multi-member LLCs. Whenever a member receives a draw during the year, his/her capital account decreases, but if the business shows a profit at the end of the year, the member’s capital account will increase in accordance with the percentage of ownership. If a member owns 25 % of the LLC, then s/he can expect to receive 25 % of year-end profits. Single member LLCs own 100 % of the entity and are entitled to 100 % of the profits. Member draws are recorded on the Balance Sheet.

A working member in a multi-member LLC has the option of either receiving a guaranteed salary amount as an LLC employee, or paying oneself with a member’s share distribution, as will a single member LLC owner. Members who are strictly silent partner investors and do not work in the business are not entitled to period draws, but will receive their member’s distribution of profits in accordance with their ownership percentage at the end of the tax year. 

The member salary, known as a guaranteed payment, is not based on the percentage split agreed upon in the LLC operating agreement but based on the work the member performs in the business. Unlike member distributions, guaranteed payments are recorded on the Profit & Loss (Income) Statement and are taken from business profits.

The LLC must be diligent about filing the correct tax forms on behalf of members and maintain accurate accounting histories for everyone throughout the year, to reflect member payment choices. Members paid as LLC employees must file IRS Form W-4 to calculate the amount of payroll tax withholding taken from from each paycheck. The member is then treated as a W-2 employee of the LLC. If the member is paid as an Independent Contractor, then s/he must file IRS Form W-9 with the LLC and the LLC must file IRS Form 1099-MISC by the end of the year. All member draws or distributions are deducted from the amount of profits assigned to the capital accounts, based on ownership percentages.

Corporations

An S Corporation is in reality either an LLC or C Corporation that has elected for special tax treatment with the IRS. S Corp income, losses, deductions and credits pass through to its shareholders’ personal IRS Form 1040. Shareholders then report the business’s income and losses on form 1040 and are taxed at their individual income tax rates. C Corps are subject to double taxation—a separate corporation tax and when dividends are paid to shareholders, that amount is recorded on IRS 1040 (but there is no payroll tax).

S and C Corporation owners who work in the business pay themselves a regular “salary” and also distribution payments. S Corp owners are usually employees of the business. Owners who work as employees must be paid a “reasonable salary” before profits (dividend distributions) are paid and the salary is subject to payroll taxes. The IRS has guidelines that define a reasonable salary, based on job responsibilities. Salaries are generally taken from business profits.

Owners of C Corps can elect to pay its shareholders a cash dividend, which is a distribution of company profits. However, the C Corp board may choose to retain either the entirety or some portion of business net profits and decline to pay a dividend in a given quarter or year. If a dividend is paid, that amount is added to income reported on the shareholder’s personal IRS Form 1040. The company records dividend payments on the Balance Sheet.

S corporation owners have been known to request that their corporations pay them little or no salary, since salaries are taxed, and instead take payments as dividend distributions, which are not taxed. The IRS has stepped up enforcement on this issue and in 2000 audited thousands of S Corps whose owner the IRS concluded had received a suspiciously low salary and very generous dividend distribution, in an apparent attempt to evade payroll taxes by disguising their salary as corporate distributions.

Thanks for reading,

Kim

Photograph: Pay day on a U.S. Navy cruiser (1942)

Starting A Business? Consider Your Legal Entity Part I

SOLE PROPRIETORSHIP

The default legal identity for the vast majority of Freelance business consultants, the Sole Proprietorship is an extension of the owner and is not a separate legal entity.  It is possible to use a separate business name (dba = doing business as) when operating as a sole proprietor—registering with the state and /or city can be a good idea—and it’s also possible to obtain from the IRS a separate business tax ID (Employee Identification Number, or EIN) and open a business bank account, both of which are recommended.  Sole Proprietorship offers no liability protection.

The tax return filed is your own.  Since there will be business expenses,  you will file schedule C along with 1040.  Deduct the portion of your home used for business on form 8829 Use of Home for Business.  See your P & L for the numbers to use for schedule C business deductions.

Quarterly estimated taxes must be paid on the 15th of January,  June and September along with the annual filing on April 15.  Remember to file the self employment tax schedule SE in April.

SMALL BUSINESS CORPORATION

To form an S Corporation is to create a separate legal entity for your business.  You must file articles of incorporation;  write by-laws for the corporation;  and elect a board of directors and officers.  It is furthermore required that annual meetings of corporation shareholders and directors be held and  official minutes for all corporation meetings be written and retained.

To set up an S Corp. choose a name for  your business (check the name availability on your state website),  get an EIN number and call the Secretary of State’s office to receive filing instructions.  The fee is about $275, paid annually.  It is recommended that you trademark your business name.

This is a relatively new form of corporate status.  As in the standard corporation, called the C  Corporation, owners and shareholders in the business are issued stock (of one class only).

To operate as an S Corp., certain conditions must be met:  the business must be a small business, must be based in the US,  may consist of 1 to 100  shareholders only  and no shareholder can be a nonresident alien.  Business owners and the business will have limited protection from liabilities, providing that no owner has been proven to be negligent.  If an owner is proven to be personally negligent, the owner will be held personally liable.

The tax return filed is the owner’s  form 1040, along with schedule E (due April 15) plus form 1120S (due March 15).  As with any business, quarterly estimated taxes must be paid, in this case using form 1120W.  Shareholders file schedule E along with their form 1040. There is no separate corporate tax.

If this is the business entity that you elect, be careful to meet and maintain all of the conditions.  Meaning, even if you are the sole owner, you must still hold annual meetings and write and retain minutes.  Failure to meet these conditions can cause you to lose the tax advantages of  S Corp. status and the business will be re-classified as a C Corporation.

CORPORATION

Known as the C Corporation, this is the granddaddy of separate business entities.  C Corp. status offers more protection against liability than any other business entity.  If you run a large business, if your business has locations in more than one state,  if the business is expected to be very long lived  and/or if the business could be subject to significant liability,  it is worthwhile to operate as a C Corp.

Stock will be issued (of any class) and stock options can be offered.  It is generally easier to raise investment capital, as stock and/or options can be made available.  On the downside, a C Corp. has comparatively larger administrative expenses, is subject to more regulatory scrutiny and is taxed at a higher rate.

To do business in this fashion select a name for the business, obtain an EIN number and file articles of incorporation with the Secretary of State for a fee of  about $275, paid annually.  It is recommended that the business name be trademarked.

Corporation by-laws must be written and a board of directors and officers must be elected.  An annual meeting must be held for directors and officers and meeting minutes must be written and retained.

The corporation  must file the annual tax form 1120 on March 15,  plus estimated taxes on form 1120W on the 15th of  April,  June,  September and December.  Business owners file form 1040 with schedule E on April 15 plus estimated quarterly tax payments on the 15th of January, June and September using form 1040–ES.

Next week, I’ll be back with 3 more options for your business legal entity.

Kim