How much should my business pay me?
There are some questions that CPAs get asked all the time. One common question from business owners is “How do I pay myself through my business?” Typically, this is quickly followed up with “How much should my business pay me for my hard work and expertise?” These are not always easy questions for your CPA to answer as there are many variables and differing circumstances that influence the answer. This article is Part 1 of our series to help you answer these questions. This article looks at variables of business structure and how that plays into paying self-employed individuals, and how the business structure determines how a business is taxed (which can play a role in determining what is paid out to owners).
Part 2 will delve into the “how much” question.
Let’s look at five basic business types and how the owners can be properly paid and how these structures are taxed:
- Sole proprietor – A sole proprietor is a business that is run by an individual who is unincorporated and pays themself through distributions. After adding up the business income and deducting the business expenses, sole proprietors will pay taxes, ordinary and self-employment, on the business’s net income regardless of whether they distribute any of the cash remaining in the business bank account. They can choose to distribute all the net income, or a portion of it. Many CPAs recommend that business owners leave at least a few months’ worth of expenses in the business bank account as a buffer or an emergency fund. Sole proprietors cannot pay themselves wages through payroll.
- Partnership – A partnership is a business owned and operated by two or more partners or individuals. Partners, like sole proprietors, cannot have themselves on payroll. The partners receive money from the partnership through one of three ways: The first is through guaranteed payments. Guaranteed payments are those made by a partnership without regard to the partnership’s net income. They are treated as if they were made to a person who is not a partner, like a subcontractor. The guaranteed payments are reported on the partner’s K-1, along with their assigned share of the net income from the business (the second way). The third way for a partner to receive money is, like the sole proprietor, when the partnership decides to distribute the cash from the business bank account throughout the year to the partners, usually based on the ownership percentages of the partners. These distributions are generally not taxed, but the owners will pay self-employment taxes on what is reported as guaranteed payments and taxes on the received net income from Schedule K-1 on their personal income tax returns.
- Corporation – A C corporation (C Corp) is a company or group of people authorized to act as a single entity and recognized as such in law; it pays its owners through dividends. The corporation will authorize a dividend distribution to the owners, based on the number or percentage of shares outstanding that each owner holds. Dividends are then taxed to each individual shareholder as a capital gain. When owners work for the corporation, then they also will receive wages for their services like any employee does and will receive a W-2 showing the total amount paid and taxes withheld on their behalf to report on the owners’ personal tax returns along with any dividends paid. The C Corp itself pays income taxes on its net income each year.
- S corporation – An S corporation (S Corp), is a corporation that elects Subchapter S status allowing the business income, losses, deductions and credits to pass through to the shareholders or owners of the business. A S corporation pays its owners through wages like other employees and withholds the appropriate payroll taxes and federal and state tax withholdings. An S Corp is required pay its owners “a reasonable wage” (discussed in Part 2 of this series). The remaining net income from the S corporation passes through to the owners and each owner will on their personal tax returns pay taxes on their portion of the net income based on their ownership percentage. Like the partnership above, the S corporation can choose to distribute all or a portion of the cash to the owners, usually based on ownership percentage. And like a partnership, these distributions are usually tax-free.
- Limited Liability Company – An LLC is a private company and pays its owners depending on how it elects to be taxed. For tax purposes, an LLC can be any of the four types of business listed above. How an LLC determines what to elect can be affected by the number of members. If there is only one member of the LLC and the owner did not elect S corporation status, the LLC will distribute the net income and be treated like the sole proprietor for taxes. If it elected S Corp status, then it will need to pay a reasonable wage to the owner(s). If there are two or more owners, LLCs without an S election default to partnership. LLC owners are legally responsible for its debts only the extent of the amount of capital they invested.
As you can see, there is no one-size-fits-all answer. There can also be a difference between what the owner was “paid” or received from the business, and what the taxable net income was from the business. It’s important to understand your business and what part of its life cycle your business is in to determine what you would like to receive from your business. In Part 2, we go into how much should you pay yourself, based on these five types of businesses and show some of the tools to use to determine what that should be. In the meantime, if you have questions on entity structures and paying yourself, please reach out to your JCCS tax professional for more detailed guidance.
* This article is not a complete listing of all the details related to this business / accounting topic and you should contact your CPA for a more detailed discussion regarding these items and how they may apply to your specific situation.
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