One of the most common questions business owners ask is “How do I pay myself?” The answer to this question depends largely on the type of business entity you have and how your company is taxed. Choosing the right method to pay yourself isn’t just about taking home a paycheck; it’s also about ensuring your business stays compliant with the IRS and that your taxes are managed efficiently. Understanding how to pay yourself correctly can save you money in taxes and help you avoid costly mistakes down the road.

Paying Yourself by Business Structure

The method you use to pay yourself varies depending on whether your business is structured as an LLC, an S Corporation, a C Corporation, or if you’re a sole proprietor or freelancer. Here’s a breakdown of each business structure and how payments are typically handled:

1.       LLC (Limited Liability Company)

An LLC is a popular choice for many small business owners due to its flexibility and simplicity. LLCs come in different forms, including single-member and multi-member LLCs, and the way you pay yourself will depend on which structure your LLC follows.

Single-Member LLC

• No W-2 Salary: As the owner of a single-member LLC, you don’t receive a formal salary. Instead, you pay yourself through what’s called an owner’s draw
• Owners Draw: This means you can withdraw money from the business whenever you need it. However, keep in mind that withdrawals aren’t taxed when you take them. Taxes are based on the overall net profit of the business, not on the amount you withdraw.
• Taxes on Net Profit: Your LLC’s profits are typically reported on your personal tax return, meaning you’ll pay income tax based on the LLC’s net profit. In addition to income tax, you will also be subject to self-employment taxes, which cover Social Security and Medicare.

Multi-Member LLC:

• Profit Sharing: In a multi-member LLC, profits are distributed to members (owners) based on their ownership percentage. Each member receives distributions and may also receive guaranteed payments.  

• Distributions and Payments: While distributions are typically not taxed when taken, guaranteed payments are considered taxable income and are reported on each member’s personal tax return.
• Tax Reporting: Members must report their share of income on their personal tax returns, and single-member LLCs, profits are subject to self-employment taxes unless the LLC elects to be taxed as an S Corporation

2.       S Corporation (S Corp)

S Corps are unique in that they allow business income to “pass through” to the owners, avoiding the double taxation typically faced by C Corporations. However, there are strict IRS requirements, particularly if you actively work in the business.

Paying Yourself a Salary

• Reasonable Salary Requirement: If you work in your S Corp, the IRS mandates that you pay yourself a “reasonable salary” for the work you perform. This salary must be paid through payroll, meaning you’ll be subject to payroll taxes.
• W-22 Reporting: Your salary is reported on a W-2 form and is subject to standard income tax and payroll taxes.

Distributions:

• Distributions After Salary: In addition to your salary, you can take distributions from the S Corp. These distributions are typically not subject to self-employment taxes, which is one reason many S Corp owners use this strategy of paying themselves a modest salary and taking the rest as distributions to minimize their tax burden.
• Tax Saving Strategy: By taking some of your income as distributions, you can potentially lower your overall tax liability since distributions are not subject to Social Security and Medicare taxes.

A “reasonable salary” is determined based on factors like industry standards, the role you play in the business, and the business’s profits. Failing to pay yourself a reasonable salary could result in penalties or an audit by the IRS.

3.       C Corporation (C Corp)

C Corporations are taxed separately from their owners, which creates a different approach to paying yourself. C Corps also offer the option to be compensated with both salary and dividends.

Salary:

• Paid as an Employee: As a shareholder of a C Corp, you can receive a salary, which is subject to payroll taxes (Social Security, Medicare, etc.) This salary is considered an ordinary business expense for the corporation, reducing the company’s taxable income.

Dividends

• Dividends to Shareholders: As a shareholder in a C Corp, you may also receive dividends, which are distributed after salary is paid. However, unlike salaries, dividends are subject to different taxation (often referred to as “double taxation” because the corporation pays taxes on its profits, and shareholders pay taxes again when they receive dividends).
• Tax Planning: The difference in tax treatment between salaries and dividends means that tax planning is crucial for C Corp owners. Many C Corp owners use a strategy that combines both salary and dividend payments to reduce their overall tax burden.

4.       Freelancers & Sole Proprietors

Freelancers and sole proprietors have a more straightforward structure, but that doesn’t mean they shouldn’t plan carefully about how to pay themselves.

Self-Employed Status:

•   No W-2 Salary: As a sole proprietor or freelancer, you don’t receive a traditional W-2 salary. You’re considered self-employed and, therefore, pay yourself through owner’s draws, transferring money directly from your business account to your personal account.

Taxes:

• Taxed on Net-Profit: The amount you pay yourself is not the basis for your tax liability. Instead, you’ll be taxed on the net profit of your business. This is reported on your personal tax return.
• Self-Employment Taxes: Like LLC owners, you’ll pay self-employment taxes on your business’s net profit. Self-employment taxes cover Social Security and Medicare and are calculated based on the total amount of income from your business.

5.       Partnerships

In a partnership, payments are typically made through distributions or guaranteed payments, similar to those in a multi-member LLC.

• Distributions: Partners receive income based on their share of the business profits, and these distributions are typically reported on personal tax returns.
• Guaranteed payments: These are payments made to partners for services or as a return on capital invested, and they are taxed as ordinary income.

Taxe & best Practice Tips

To ensure that your business and personal finances remain compliant and organized, it’s essential to follow certain best practices when paying yourself.

1.       Set Aside Money for Taxes

• Whether you’re paying yourself a salary, taking distributions, or making owner’s draws, always remember that taxes will need to be paid on the money you take from the business. Set aside a portion of your earnings throughout the year to avoid a tax surprise at the end.

2.       Separate Business and Personal Finances

• It’s crucial to keep your business and personal accounts separate to ensure clear financial records and avoid any issues with the IRS. This will also make it easier to track your business expenses and deductions.

3.       Pay Yourself Regularly

• If your cash flow allows, paying yourself a consistent salary or draw can help you manage your personal budget and avoid financial strain. This regular income also ensures that you maintain a healthy work-life balance.

4.       Keep Accurate Records

• Maintain detailed records of any salary, draws, and distributions you take. Accurate bookkeeping is essential not just for tax reporting, but also for making informed business decisions.

5.       Consult a Tax Professional

• Every business is different, and the rules around paying yourself can be complex. A tax professional or accountant can help you navigate these waters, ensuring compliance with IRS regulations and helping you strategize on the best ways to minimize your tax burden.

Bottom Line: Paying Yourself Correctly Matters

The way you pay yourself depends on the structure of your business, but the key takeaway is that it requires careful planning. Whether you’re an LLC owner, S Corp shareholder, or sole proprietor, understanding the nuances of how you pay yourself can have significant financial implications. By following the right procedures, setting aside money for taxes, and consulting with a tax professional, you can avoid costly mistakes and maximize your tax savings. Paying yourself properly helps you keep your business in compliance with the IRS and can ensure your personal finances stay in good shape as well.