Your small business entity type will most likely determine how your compensation is distributed
Owner’s Draw or Salary? Many small business CEOs ponder this question. In this column I will rely on and answer this question as written in a recent blog posted on the SCORE website by Drake Forester, Legal Strategy Officer, Northwest Registered Agent. He is a content partner of SCORE and writes extensively about small business issues and specializes in translating complex legalese into language everyone can understand. His writing has been featured on Fox Small Business, AllBusiness.com, Score.org and many other websites and blogs. I value his expertise and share it here.
The method you use to take funds out of your business depends, in large part, on your entity type.
If you are a sole proprietor, a partner in a partnership, or a member of a standard LLC, you will likely pay yourself with an owner’s draw. This is the most flexible payment method, allowing you to withdraw cash from your company’s equity account (your business earnings plus any capital you have invested in the business) at any time.
If you are the owner of a business taxed as an S-Corp or a C-Corp, and you’re actively involved in running the company, the rules are bit more rigid. The IRS requires employee-shareholders of corporations to be paid reasonable compensation for their work, in the form of W-2 wages.
In the process of starting a new venture. You will want to reflect on your preferred method of taking funds out of the business before you settle on an entity type.
If you need the flexibility of any-time cash withdrawals, operating as a sole proprietor, a partnership, or an LLC with default taxation will allow you to use the owner’s draw method.
If you prefer the stability of a regular paycheck (and would rather pay taxes on your earnings up front rather than later on), forming a corporation or an LLC taxed as an S-Corp or C-Corp will make it possible for you to pay yourself as a salaried employee.
Business owners looking for a middle ground should note that there is a little leeway when it comes to S-Corps. In a business taxed as an S-Corp, owners have the option to supplement their regular salary with an owner’s draw.
Guidelines for Sole Proprietors, Partnerships & LLCs
As noted earlier, being a sole proprietor, a partner in a partnership, or the owner of an LLC means using an owner’s draw to pay yourself—at least in most cases. While this may be the simplest way to take money out of your business, you should be aware of a few guidelines and best practices for each business type.
For business owners operating as sole proprietors, the owner’s draw is the only legally allowed payment method.
You can take funds out of your business at regular intervals (or anytime they are needed) by writing yourself a check, making a cash withdrawal at the bank, or transferring a sum from your business account to your personal one. Careful record-keeping is critical: each time you withdraw cash from your business for personal use, be sure to note the amount on your company’s balance sheet. Maintaining a clear separation between your business and personal finances will give you a clearer picture of your company’s profitability and remaining equity.
Planning ahead for tax time is also key. Any money you receive from your business in the form of owner’s draws will be taxed on your personal income tax return, at the self-employment rate of 15.3 percent. This means that for each cash withdrawal, you’ll need to set aside this percentage for your annual or quarterly tax payments to the IRS (most business owners pay their taxes quarterly).
Partnerships are pass-through entities—each partner’s share of the business profits flows through to their personal income tax return. As with a sole proprietorship, you’ll use an owner’s draw to pay yourself, and will owe self-employment taxes on these funds come tax time.
Where partners differ from sole proprietors is that each partner’s equity is distinct. You can only withdraw funds up to the amount of the capital that you, as an individual, have contributed to the business.
In addition to taking an owner’s draw, partners have the option of being compensated through guaranteed payments. These are regular payments made to an individual partner for their services or investment in the partnership, made regardless of whether or not the company is successful. Unlike an owner’s draw, a guaranteed payment is considered a deductible business expense and reduces the net profit of the business.
By default, LLCs are generally treated like partnerships in terms of taxation, and owners (called members) cannot be compensated with W-2 wages. As an owner of an LLC, you will pay yourself with an owner’s draw.
To safeguard your liability protection, you will need to do your best to keep personal and business accounts separate. This means carefully recording every owner’s draw you take.
If you’d prefer to pay yourself a salary or wages as an LLC owner, this option is available to you. However, you would first need to apply for S-Corp or C-Corp tax treatment, which may have other tax implications for your business.
There’s more to paying yourself with an LLC than meets the eye, and you’ll want to sit down with your accountant or tax professional to determine the method that will result in the greatest tax savings and business growth.
Guidelines for S-Corps and C-Corps
If your business is taxed as a corporation, you are required to pay yourself W-2 wages, and these wages will be subject to tax withholding.
Unfortunately, the IRS does not provide a clear-cut definition of what constitutes “reasonable compensation,” so it will be up to you (and perhaps your accountant or tax professional) to determine a reasonable wage based on what other companies are paying their officers. Keep in mind that reasonable compensation is based on the value of services provided, not the company’s profitability. Outsourcing your payroll to a third-party provider can help to take some of the guesswork out of paying yourself (and any other employees) and set you up for an easier tax season.
In addition to paying themselves a reasonable wage, owners of S-Corps can supplement their income with an owner’s draw (referred to as a distribution, in this case). However, things can get tricky if an S-Corp has multiple shareholder-employees, and if distributions between all shareholders are not equal. This is because S-Corps are legally required to have only one class of stock, and the IRS views disproportionate distributions as evidence that a corporation has a second class of stock.
If the IRS believes this is the case with your company, you could be taxed as a C-corp (at the rate of 21 percent).
As the owner of a C-Corp, your salary needs to meet the IRS guidelines on reasonable compensation mentioned above. If you need to withdraw money from the company (above your salary) it must be paid out as a dividend, as the owner’s draw method is not legally allowed. Another option available to you is supplementing your income in the form of bonuses. A bonus, like your salary, is a tax-deductible expense and will lower your corporation’s total taxable income. Just be careful to not pay yourself “unreasonably high” compensation (via your salary or bonuses), as the IRS views excessive compensation as disguised dividends, which are not tax-deductible.
Tax rules for corporations are complex—once you have mapped out your personal expenses and have an idea of what you want to pay yourself (and how you want to do so), work with your CPA or tax professional to ensure your corporation is tax-compliant.