It’s likely been a long haul to get your new business to a position where you can start taking some money out of the business.
So, you’re ready to pay yourself!!! Yay!!!
I get questions from small business owners quite often on how/when to pay themselves. There is no easy answer to this question though. It all depends on the type of entity you are. If you are still in the development phase of your business, but are close to going to market, you should definitely consult a CPA and a small business attorney to help you decide on the type of entity which makes the most sense for YOU. This decision is known as “Choice of Entity”. It’s a very important decision for you and will impact other decisions about your business. I recommend consulting both a CPA and an attorney because they will look at the decision from different viewpoints. The CPA can help you understand the tax ramifications of each entity choice whereas the attorney can help you with risk mitigation.
Many of the start-ups I work with begin by paying their employees and take no pay themselves for a while. Once they have gotten some traction and are earning some profits, it’s time for them to decide how to start benefitting from that personally!
Generally, you have two options. Taking a salary or taking a draw/distribution. Some entities mandate one or the other type of pay, whereas others may require both.
Here’s some help for you in understanding your choices.
If you are an officer in a corporation, typically known as a C Corporation, the law says you must be on the payroll and receive regular checks that include withholdings for Social Security, Medicare, federal income taxes, and state income taxes in states that require them.
Owners of S Corporations have particularly tricky options. An S Corporation is known as a pass through entity, meaning that you can take out much of your money via draw or distribution, which typically are paid without the withholding of taxes, and are then taxed on your personal income tax return. However, there is a pesky IRS rule known as “Reasonable Compensation” which requires you to take a taxable salary. Although there is no specific formula for calculating this “reasonable compensation”, a great guideline is to pay yourself an amount similar to what another business would pay someone to do what you do. Or you can look at it as what would you have to pay someone else to do your job.
Paying yourself only via draw/distributions puts you in a position of having to pay the IRS interest and penalties for incorrect payroll tax reporting.
TIP! If you have only taken draw/distributions so far this year, you need to speak with your CPA very soon about what you should pay yourself in salary by the end of the year.
Sole Proprietors and Partners
Sole proprietors and members of partnerships may pay themselves by moving money from their business account to their personal account whenever they’d like. Their is no requirement for payroll tax withholdings, in actuality you are not allowed to take salary. However each individual in these types of entities will pay their payroll taxes on his or her personal tax returns.
I’ve seen many Sole Proprietors who never did pay anything to the IRS during the course of the year, thereby triggering interest and penalties. One of the easiest ways to avoid these interest and penalties is to pay quarterly estimated tax payments. Your CPA or tax return preparer can help you to identify what you should pay each quarter and will often send you coupons which you can use to make the payments.
Congratulations again on achieving the big milestone of becoming profitable enough that you can now be paid for your efforts.
If you need help with any of these decisions, or a referral into a great CPA, don’t hesitate to contact me.