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How Should You Pay Yourself? Advice for Small Business Owners

Small Business

Are you the last one to be paid once you’ve run payroll and paid all your bills?

You may have never given any thought to the way you pay yourself. After all, it is your business, and you deserve to get paid! But it’s not as simple as that.  Depending on your business structure, you may need to put yourself on the payroll.

I posed this question to Todd Schmitt, CPA, and treasurer of Patriot Software:  How should small business owners pay themselves?

According to Mr. Schmitt, it depends on your business structure, so you should consult your accountant or attorney for advice. But in general:

Sole proprietors
If your business is a sole proprietorship, you can use a draw account to track money and other types of payments that you take from the business. You may want a consistent way to compensate yourself, such as a salary, so your business won’t be hurting for cash. In that case, you can develop a weekly, bi-weekly, or monthly draw schedule to pay yourself. Depending on how well your business performs, you can also supplement your income on a quarterly or annual basis.

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Partnerships
If you are in a partnership, you are not an employee of the business. Like a sole proprietor, you should show money that you take from the business in a draw account. As a partner, you can take “guaranteed payments” for service rendered, and taxes are not withheld from payments (because you are not an employee). Unlike draws in a sole proprietorship, however, these payments are deductible by the partnership and considered taxable income to the partner for income taxes and self-employment taxes. A partner can also receive some fringe benefits from a partnership, but you must report the value of the benefits as taxable income on your personal tax return.

Corporations
You are generally considered an employee if you are a corporate officer of the company. As such, you will need to deduct for income taxes, Social Security, Medicare, and any other applicable taxes. However, according to the IRS, if you are an officer who performs no services or only minor services, and you don’t receive any pay, you are not considered an employee. For more information, refer to “Who Are Employees?” in Publication 15-A, Employer’s Supplemental Tax Guide.

If you are an officer of a corporation, and you’re on the payroll, you also need to make sure you’re paying yourself enough. According to the IRS definition of “reasonable compensation,”  “wages paid to you as an officer of the corporation should generally be commensurate with your duties.” So that means that if you are the president of a million-dollar corporation, your salary should reflect your responsibilities in the company. For more information on reasonable compensation, refer to “Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses.

Mr. Schmitt added that some S-corp owners may try to avoid payroll taxes by not taking a salary at all, and instead taking cash out of the business via a distribution. However, if the IRS determines that the distributions should be characterized as wages, the taxes and penalties can add up very quickly. And if you issue yourself a 1099-MISC instead of adding yourself to the payroll, you may be liable for Social Security, Medicare, and income tax, as well as a possible trust fund recovery penalty.

For more information on how to pay yourself, visit the Internal Revenue Service website.

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