In most cases, paying yourself a consistent income that at least meets your base personal needs should be the first and highest priority of your business. And when you pay yourself in the right way, you can also minimize your taxes, while ensuring your business has what it needs to grow as well.
Of course, owning your own business also means that if your company doesn’t earn enough money, you might not get paid at all. And in the worst-case scenario, if you don’t structure your business’ legal, financial, and tax systems properly, you could even find yourself in a situation in which you don’t get paid, and at the end of the year you end up owing taxes that your company can’t afford to cover.
Your entity structure matters
Given all that, what’s the right way to pay yourself from your business? The first consideration regarding how you pay yourself depends on the type of business entity structure you use to establish your business. In order to protect yourself from being held personally liable for debts and lawsuits related to your business and save on taxes, we often advise entrepreneurs to structure their business as a Limited Liability Company (LLC).
In addition to the personal liability protection offered by an LLC, the entity offers you flexibility in how your business will be taxed—and how you get paid. But, without the right choice of how your LLC is taxed, you could end up with a surprisingly large tax bill. Unless you elect for your LLC to be taxed as an S-Corporation, single-member LLCs are automatically taxed as sole proprietorships, while multiple-member LLCs are taxed as partnerships.
If your business is taxed as a sole proprietorship or partnership, you will pay payroll taxes (FICA) and income taxes (both state and federal) on all income earned by the business, less deductions. That means all income earned by you via a 1099 or paid to your LLC, is reported on Schedule C of your personal tax return. After expenses are deducted, the remaining income is subject to payroll taxes (FICA taxes are 15.3%) as well as both federal and state income taxes.
This is why many entrepreneurs who own LLCs and don’t choose to be taxed as S-Corp often find themselves surprised by a big tax bill that doesn’t seem to make sense, given their total earnings.
To avoid such a hefty tax bill, consider filing an election to have your LLC taxed as an S-Corporation. By doing so, you can minimize your payment of FICA taxes by paying yourself a salary via payroll. Then you would only pay the 15.3% FICA taxes on the amount paid to you via payroll, but you wouldn’t have to pay the 15.3% on the rest of the money you take out of the business in the form of a dividend, profit distribution, or an owner’s draw, which are simply different names for the same thing. And obviously, this can result in significant tax savings.
To make paying yourself as easy and efficient as possible under an S-Corporation election, you could use a payroll service, such as Gusto or ADP, which would handle all the paperwork and tax aspects of your payroll. Note that the IRS requires that the amount you pay yourself via payroll must be “reasonable compensation.” What constitutes reasonable compensation is a subjective matter, so talk with us and your tax advisor to ensure you’re paying yourself an appropriate amount.
Maintain the financial health of your business
To help you choose the entity structure, tax treatment, and payment method that work best for your business, meet with us as your Family Business Lawyer® today. We specialize in helping entrepreneurs set up effective financial systems to maximize profits, minimize tax liabilities, and avoid any unneeded scrutiny from the IRS.
This article is a service of Erin Williams, Family Business Lawyer®. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule. 720-312-1874