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The Different Ways
Business Owners
Can Pay Themselves
BY: DAVID CHENG
AS AN OWNER, YOU HAVE A LOT OF RESPONSIBILITIES. THAT’S WHY IT’S SO
IMPORTANT TO PAY YOURSELF APPROPRIATELY FOR ALL THE WORK YOU DO.
BUT DID YOU KNOW THERE ARE DIFFERENT TAX IMPLICATIONS ON THE DIF-
FERENT WAYS YOU CAN PAY YOURSELF? IN THIS POST, WE’LL COVER SALA-
RIES, DIVIDENDS, LOANS, AND OWNER’S DRAW.
YOUR BUSINESS ENTITY MATTERS
As a business owner, you can structure your
business as a sole proprietorship, a partnership,
cooperative, an LLC, an S-Corporation,
or C-Corporation.
The Sole Proprietorship is the most basic
type of business entity. All the assets belong
to the business owner, but also the liabilities.
Because of this, your business is not taxed
separately. Instead, your business’s income
is your income, and you report it with a
Schedule C and the standard Form 1040.
If you are in a business with one or more
partners, you could consider a Partnership.
Unlike a sole proprietorship, a partnership
needs to register with the IRS and state and
local tax revenue agencies. A partnership
does not pay income tax; instead, the profits
pass through to the partners. A partnership
files a Schedule K-1 and Form 1065.
A Limited Liability Corporation (“LLC”) is
a lightweight alternative to incorporate your
business. It combines the tax pass throughs
of a partnership and the limitations in lia-
bilities of a corporation. An LLC is not taxed
as a business entity. Rather, the profits are
passed through to the LLC’s members and
they are taxed as personal income.
A Cooperative is similar to an LLC in that it is
also a corporation and does not pay federal
taxes. Rather, profits are passed through to
the cooperative’s members. A cooperative
is different from any other business entity
because of its specific rules for membership
and operations. Typically, a cooperative’s
members must agree on matters like its bylaws
and operations in a democratic fashion.
If you’re looking to incorporate your business
and have it taxed separately, an S
Corporation is a popular choice amongst
small businesses. Since the S Corp is taxed
as its own entity, a business owner and its
employees can see tax savings since they will
only be taxed on their wages. An LLC has an
option to file as an S Corp for tax purposes.
It’s worth noting that not all states recognize
the S Corp distinction from a C Corp.
The last business entity option is the C Corp.
C Corps are less popular amongst small
businesses because it is more complicated
than the other options and typically has
costly administrative fees. One of the major
drawbacks of the C Corp is the “double taxation.”
A C Corp is taxed twice–once when
it makes a profit and again when it distributes
dividends to its stockholders. However,
for many fast growing startups, the C Corp
is popular because it can offer stock in exchange
for an ownership stake.
HOW TO PAY YOURSELF
Now that you know about the different business
entities, it’s time to understand all the
different ways you can pay yourself, depending
on your business entity.
Many business owners are W-2 employees.
The W-2 is issued by an employer if the
employee earns $600 or more in wages or
equivalent. W-2 employees are subject to
withholding taxes, which are taken each pay
period. A withholding tax is a pay-as-you-go
tax to the IRS and can be calculated through
the W-4 and their IRS withholding calculator.
These three things determine how much you
withhold from your employee:
• Marital status
• The number of allowances claimed on
the W-4
• Compensation (Note: This may depend
on the State where your employee receives
payroll.)
Employees who anticipate a full refund may
be exempt from withholding. This is different
from employees who are exempt, like clergy
or certain visa holders. The functionality
of having your taxes withheld is one reason
why some owners choose to be W-2 employees.
The inverse is also true though. Some
business owners who want to pay taxes separately
may opt out of W-2 wages. The IRS
may check on business owners who do not
pay themselves a “reasonable compensation”
to avoid paying withholding taxes.
Business owners can also receive a dividend.
Dividends are not taxed if it is a return
of capital to the shareholder. Most dividends
are paid out in cash, but you can also have a
dividend of stock or other assets.
Some owners may choose to loan themselves
money through their business. A shareholder
loan must have a stated interest rate, a
maturity date, and covenants for non repayment.
There is some risk though. If the loan
is below-market, it will be treated as a gift,
dividend, contribution to capital, payment
of wages, or other payment, depending on
the substance of the transaction.
Finally, a business owner can choose to do
an owner’s draw. Unlike W-2 wages, a draw
is not taxed at the company level. If you are a
sole proprietor or a partner in a partnership,
your income is a draw. However, it’s also
possible to do an owner’s draw as an LLC or
even an S-Corp.
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