Own A Business? Don’t Put Yourself On Payroll Before Reading This

Ah, the wonders of a successful business! It’s finally making enough money to give you the paycheck you wanted… and you’re probably going to get into a lot of trouble if you just stick yourself on the payroll.

Yes, I’m serious – there are legal aspects to compensating yourself if you own the business that’s paying you, and we’re going to go over those today.

Categorizing Your Business

How you can compensate yourself depends on the type of business you run.

  • Sole Proprietorship or Partnership: In most cases, you’re not allowed to be on payroll. You can still pay yourself from the company’s income, but that pay is not tax-deductible. Partnership agreements allow for pay to be given in various ways, but it’s usually best to take distributions and make estimated tax payments.
    • In both sole props and partnerships, you’ll pay self-employment tax on the full amount of business profit each year. That’s about 15% of your net profits, so be sure you’re making those estimated tax payments to avoid a big tax bill at year-end.
    • It’s best to have payments made on a regular basis, rather than drawing out pay whenever you feel like you need (or want) it. This isn’t necessary, exactly, but it does tend to result in better organization and a more accurate understanding of what it costs you to run your business.
  • Corporations: Officers (which business owners are) are required to be paid as W-2 wage earners. You’re almost certainly subject to standard taxes, but on the bright side, the pay you take can be deducted as a business expense.
  • S Corporations: S Corporations are similar to standard Corporations, but you can also pay yourself through tax-free distributions. Don’t start celebrating – you still need to take an amount in payroll that the IRS would call “reasonable”, which usually means compensation similar to what similar people in similar positions receive. And while distributions are free from Social Security, Medicare, and unemployment taxes, you’ll still need to pay federal and state income taxes on them when you file your personal tax return at year-end. One last thing: keep in mind that your payroll will be a tax-deductible business expense, but your distributions won’t be.
  • Limited Liability Companies: These companies are regulated based on state laws, not federal laws. If you have an LLC, the IRS defaults your tax status to either sole proprietorship (if you’re the only owner) or partnership (if there are multiple owners). Alternatively, you can elect S Corporation status with the IRS for tax purposes. As noted above, this tends to be more favorable tax-wise than the distribution-only method that sole proprietorships and partnerships have to deal with.

Don’t Try To Cheat The System

The IRS is increasingly focused on individuals who receive a lot of money in the form of distributions – after all, certain taxes aren’t being paid on that, and the IRS isn’t fond of folks that skirt the tax laws.

How much to pay yourself in salary versus distributions is a controversial topic, even among financial professionals. It’s okay to minimize your salary and take more in distributions, as long as your salary can be defended as a reasonable amount. There are some online tools that can help, or your CPA can help guide you to a wise decision.

Just remember that pigs get fat, hogs get slaughtered. If you pay yourself an aggressively low salary, while taking giant distributions, it’s only a matter of time before the IRS comes knocking. Be reasonable, and stay safe.

Changing Your Business Setup

If you have an existing sole proprietorship or partnership, it’s possible to change your election with the IRS to be taxed as an S Corporation. If your business is netting at least $40,000/year in profits, that’s usually the point where it makes sense to investigate alternative entity structures to cut down your tax bill. We know some quality tax experts who can discuss this with you, so shoot us a message if it’s something you’d like to investigate further.

Are you a CPA, EA, or Tax Advisor who assists clients with S Corp elections and advises on reasonable compensation? Don’t “wing” it and leave yourself and your clients open to IRS challenges. We recommend a tool called RCReports to calculate accurate & defensible shareholder wages. Click the link below for an exclusive discount through Cirrus Payroll’s partnership with RCReports.

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