How do you pay yourself as the business owner? Learn 4 ways to get paid!
Let’s face it. We may love what we do and relish being business owners, but ultimately it’s about getting paid. Basically, “Show me the money!” right? Well, being a business owner can be a little different from back in the employee days when you didn’t have to think about all of the extra details that come with being a business owner.
Practically speaking, this might mean cutting yourself a paycheck like you received when you were an employee – by writing yourself a check or setting up a wire transfer from your business bank account to your personal account.
Which brings us to a fundamental and essential “must-do”: You should definitely have separate bank accounts. Do not commingle personal and business funds.
So the actual physical activity of paying yourself as the business owner isn’t that complicated. But, what you really want to nail down is how to account for your paycheck.
How you pay yourself as the business owner may depend on the legal form of your business.
If you are a sole proprietor or a partner in a partnership, you will usually pay yourself by owner’s draw. It is also possible to do an owner’s draw as an LLC or even an S-Corp. Unlike W-2 wages, a draw is not taxed at the company level. Since draws are not taxed, it can be difficult to determine an appropriate draw amount. While the company is not taxed, the business owner has to pay self-employment taxes. When you’re completing your Schedule C, you’ll also complete form 1040-SE. That form is used to calculate your self-employment taxes. These taxes are the equivalent to the FICA taxes — for Social Security and Medicare — on a W-2 paycheck.
If a company is formed as an S Corporation, they can pay themselves as a W-2 employee. Same is true with an LLC if they claim to file taxes as an S Corporation. The functionality of having your taxes withheld is one reason why some owners choose to be W-2 employees. The inverse is also true though. Some business owners who want to pay taxes separately may opt out of W-2 wages.
A W-2 is issued if the employee (owner) earns $600 or more in wages or equivalent. W-2 employees are subject to withholding taxes which need to be reserved each pay period. A withholding tax is a pay-as-you-go tax to the IRS and can be calculated using the allowances on the W-4 and the IRS withholding calculator. Three things determine how much should be withheld from your pay: marital status, the number of allowances claimed on the W-4, and Compensation. (Note: This may depend on the state where you are paid.)
The IRS may check on a business owner who does not pay themselves a “reasonable compensation” to avoid paying withholding taxes. As your business grows but is still in startup phase, you might consider commission-based payments. This allows for payments based on profitability. For a developing business, you could pay yourself by using a market-based wage. A market based wage can be determined by establishing average pay rates in your industry, position, age of the business, revenue, and experience. For a business that is more established, consider moving to an experience-based salary that compensates you for your time, knowledge and skills. An experience based salary can be established by conducting research among industry peers to determine the average pay rate for someone of your experience, knowledge, and skills.
Business owners can elect to receive a dividend. Dividends are not taxed if it is a return of capital to the shareholder. Most dividends are paid out in cash, but you can also have a dividend of stock or other assets. This is best done when there has been clear accounting of the equity investments made by the business owner. Equity accounts are the accounts that show how much money the owner would be able to take from the business if they were to sell off all their assets and pay off all the money owed to other businesses and people. Contributions by the owners and income from the business increase these equity accounts, and owner withdraws and business losses decrease them. Sole proprietor and LLCs report all the income from their business on Schedule C of their tax return. This income then rolls on to the business owner’s 1040 form where the usual tax is calculated – your accountant may have additional advice on how to report dividends on your tax return.
Some owners may choose to loan themselves money through their business. A shareholder loan must have a stated interest rate, a maturity date, and covenants for non-repayment. This is not without risk; if the loan is below-market, it will be treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction which has tax implications.
The differences in how you pay yourself when you’re a business owner as compared with how you are paid as employee are significant. It is important to understand these differences before you write yourself a check. Remember that your choices have consequences, not least the tax consequences that follow how you pay yourself as a business owner. When you’re an employee and get a regular paycheck, taxes are taken out each pay period — this means avoiding a rude shock when tax time rolls around. When you’re a business owner, unless you make quarterly payments, you’ll owe taxes on your entire year’s income when you file your return. Remember also that regardless of how you choose to pay yourself, you need to make sure you’re compliant with the IRS and paying yourself a reasonable compensation.
In addition to a knowledgeable small business attorney, a good bookkeeper and an accountant or tax advisor can be valuable assets to your business. In fact, you should ask an accountant if you have additional questions about paying yourself! Remember to ask questions before you start paying yourself, so you don’t end up with an unexpected tax bill.