As a new business owner, you have plenty to keep you up at night. But nothing is more stressful than bookkeeping woes.
One of the most common errors in a small business relates to how the owner takes payment. Owners need to be careful about how they pay themselves because it affects their books and their taxes. The foundation of payroll is business type. The next step is understanding the difference between the two most common forms of “owner salary.”
Business Owner Dividend/Salary: C Corporation
Business owners of C corporations pay taxes at the entity level, which could result in double taxation if the owners take dividends from the corporation. The business will pay taxes on the profits, and then the owner will pay taxes at the personal level on the dividend. The strategy to avoid double taxation is for owners to take salary/bonus and pay taxes at the individual level. This is called “zeroing out the corporation.”
A downfall of this strategy is it subjects 100% of the owner’s income to FICA tax. Business owners of C corporations are cautioned not to treat draws as traditional salary. Positive cash flow is an essential requirement if you want to ensure the financial stability of your business.
Distributive Share: Partner, Multi-Member LLC
The allocation of income, loss, deduction or credit from a business to an S corporation owner, LLC members (where there is more than one), or partner in a partnership is known as a distributive share. The percentage of share is usually spelled out in an operating agreement and always totals 100%. When no agreement exists, distributive shares correlate to each partner’s share of ownership. The calculations are based on the following factors:
- Interests in the economic or taxable income of the partnership
- Capital contribution
- The rights of partners to partnership assets should the company be sold or file for bankruptcy
The process of taking a distributive share requires an accounting of the total net income. That profit is then divided among the partners according to their shares or the partnership agreement.
Partners’ distributive shares of income from the partnership are subject to self-employment tax as well as normal income tax.
Business Owner Distribution/Salary: S Corporation
One of the most common entities for a business owner is an S corporation. S corporations have the benefit of not being double taxed like a C corporation by passing through the income to be taxed by the shareholders at their pro rata ownership. This allows the owners to enjoy a lower total tax rate on the business income and not face double taxation on the profit distributions.
The S corporation profit is also not subject to self-employment tax. In turn, the S corporation must pay the owner reasonable compensation for the services performed. While this is not defined anywhere, it is subject to frequent scrutiny by the IRS to make sure the owner is paying enough compensation for the type of work being done.
Draws: Sole Proprietor, Single-Member LLC
Sole proprietors and single-member LLC owners, which the IRS considers sole proprietors for tax purposes, must do a little more budgeting to get paid.
The IRS does not allow sole proprietors and single-member LLC owners to pay themselves a salary, so they are “paid” by drawing money down from their businesses’ capital. Since the “payments” are not an expense for the business, there are no deductions or withholdings for:
- FICA taxes (Social Security and Medicare),
- federal income tax,
- state income tax, or
- any other employment taxes.
That means sole proprietors and single-member LLCs must pay self-employment tax, which is calculated on how much profit the business made and added to the income tax due when they complete their individual returns. This leads most sole proprietors and single-member LLCs to make quarterly estimated tax payments to avoid paying even more in underpayment penalties when the annual Schedule C is filed.
While draws don’t necessarily impact a business’ profit, the owner can only draw enough each time to ensure the business can pay necessary expenses to keep the doors open. Remember, too, that sole proprietors and single-member LLCs are taxed on the profits of the business, not the draws, so keeping business and personal spending and accounts separate is key to minimizing tax liability at the end of the year.
Table: Best Practices of How Owners Should Pay Themselves and How Pay Relates to Tax Returns
|Business Type/Owner Status||How to Pay Yourself||Tax Return to File||Subject to Self-employment Tax|
|Partner||Distributive share||Schedule K-1 for 1040||Yes|
|Sole proprietor||Draw||Schedule C for 1040||Yes|
|Single-member LLC||Draw||Schedule C for 1040||Yes|
|Multiple-member LLC||Distributive share||Schedule K-1 for 1040||Yes|
|Corporate owner||Dividends||Dividend income on 1040||Not on dividends|
|S corporation owner||Distributive share||Schedule K-1 for 1040||No|
|Corporate exec/employee||Paycheck||W-2 income on 1040||FICA (employee)|
Frank Granatino, CPA, of Goering & Granatino is a graduate of Missouri State and a CPA, but, moreover, he is a problem solver who uses his deep knowledge and understanding of the industry to find ways to do things faster and more efficiently for his clients. From creating customized reporting templates to spending time with his clients to educate them on how best to organize their businesses, Frank helps companies perform at their best. Often, we have clients comment that Frank feels like a member of their teams. He gets in there, rolls up his sleeves and makes things happen.