Now that you set up your business and started making money, you need to pull some cash out of the company to pay your personal bills. But how do you small business owners pay themselves?
The answer depends on the type of structure. Business owners are paid differently, depending on if they’re a sole proprietor, S, Corp., C, Corp., or partnership. There are pros and cons to each of the different payment methods. Some will have employment taxes, and some not.
This post will give you insight into how you did and how to take money from your business. In practice, you should review these options before setting up the plan to ensure you’ve accounted for your distributions properly.
How do small business owners pay themselves?
Small business owners can pay themselves in various ways depending on their business’s legal structure, personal financial needs, and tax considerations. Here are some common ways that small business owners can pay themselves:
- Drawings: If the business is a sole proprietorship or a partnership, the owner can take money out of the company as a draw. A draw is simply a distribution of profits from the business to the owner’s personal account. Drawings are not subject to payroll taxes or income tax withholding. However, the owner is responsible for paying income taxes on the money they draw from the business.
- Salary: Business owners who have incorporated their business can pay themselves a salary. A salary is a fixed amount of money paid to the owner regularly. The salary is subject to payroll taxes and income tax withholding. Business owners who pay themselves a salary must also file quarterly payroll tax returns and annual W-2 forms.
- Dividends: If the business is a corporation, the owner can pay themselves a dividend. A dividend is a distribution of profits to shareholders. Dividends are not subject to payroll taxes, but they are subject to income tax. Business owners who pay themselves a dividend must also file a 1099-DIV form.
- Owner’s Draw: LLCs and S corporations can use owner’s draws as a way to pay themselves. An owner’s draw is a distribution of profits to the owner’s personal account, similar to a draw in a sole proprietorship or partnership. Owner’s draws are not subject to payroll taxes or income tax withholding. However, the owner is responsible for paying income taxes on the money they draw from the business.
Small business owners must keep track of their business finances and separate them from their personal finances. This helps ensure that the business operates efficiently, and that the owner takes appropriate compensation. Small business owners should also consult with a tax professional or financial advisor to determine how small business owners pay themselves.
What is Self-Employment Tax?
Self-employment tax is paid by individuals who work for themselves, including business owners, freelancers, and independent contractors. This tax is used to fund Social Security and Medicare programs and is calculated based on an individual’s net self-employment income.
Self-employment tax is different from regular income tax, which is paid by individuals who earn income from employment. When you are an employee, your employer withholds a portion of your pay for Social Security and Medicare taxes. As a self-employed person, you are liable for paying the full amount of these taxes on your own.
If you are self-employed, you are liable for paying self-employment tax. This tax comprises two parts: Social Security tax and Medicare tax. The Social Security tax rate is 12.4% for 2023, with 6.2% paid by the employer and 6.2% paid by the employee. The Medicare tax rate is 2.9%, with 1.45% paid by the employer and 1.45% paid by the employee. In total, the self-employment tax rate is 15.3%.
For example, if you have self-employment income of $100,000, you would owe $15,300 in self-employment tax.
What about corporations?
An S corporation is a particular type of business structure that provides pass-through taxation to its owners. This means that the business’s profits and losses are just passed through to the owners’ personal tax returns rather than being only taxed at the corporate level. This structure is popular among small business owners because it can provide tax benefits while maintaining a corporation’s limited liability protection.
Owners of S-corps can also take a salary from the company, just like any other employee. The salary is subject to payroll taxes, including Social Security and Medicare taxes, and is typically reported on a W-2 form.
One of the critical considerations in determining an owner’s salary is the fair market value of the owner’s services.
The IRS requires that S-corp owners receive reasonable compensation for their work, just like any other employee. If the owner’s salary is too low, the IRS may reclassify some of the owner’s draw as salary, which would then be subject to payroll taxes.
To determine a fair salary, S-corp owners should consider several factors, including:
- Industry standards: Owners should research the average salary for similar positions in their industry to determine what is reasonable.
- Company revenue and profits: The company’s revenue and profits should also be considered when determining an owner’s salary. Owners should consider how much they contribute to the company’s success and factor that into their salary.
- Time and effort: Owners should also consider the time and effort they put into the business. If the owner works full-time and contributes significantly to the company’s success, they should receive a higher salary than someone working part-time.
- Other compensation: Owners should also consider any further compensation they receive from the company, such as bonuses or stock options.
In conclusion, the method of paying oneself as a business owner depends on a variety of factors, including the business structure, profitability, and personal financial goals. As a sole proprietor, it is common to pay oneself through an owner’s draw or by taking a portion of the profits. For partnerships, each partner may receive a share of the profits based on the terms of the partnership agreement.
For those operating as an S-corp, it is important to follow IRS guidelines and pay oneself a reasonable salary in addition to any distributions or dividends. Ultimately, it is important for business owners to work with a financial professional or tax advisor to determine the most effective and tax-efficient way to pay themselves while also ensuring the financial health and stability of the business.