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 proprie<strong>to</strong>rship, a partnership, cooperative, an LLC, an S-Corporation, or C-Corporation. The Sole Proprie<strong>to</strong>rship is the most basic type of business entity. All the assets belong <strong>to</strong> 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 proprie<strong>to</strong>rship, a partnership needs <strong>to</strong> register with the IRS and state and local tax revenue agencies. A partnership does not pay income tax; instead, the profits pass through <strong>to</strong> the partners. A partnership files a Schedule K-1 and Form 1065. A Limited Liability Corporation (“LLC”) is a lightweight alternative <strong>to</strong> 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 <strong>to</strong> the LLC’s members and they are taxed as personal income. A Cooperative is similar <strong>to</strong> an LLC in that it is also a corporation and does not pay federal taxes. Rather, profits are passed through <strong>to</strong> 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 <strong>to</strong> 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 <strong>to</strong> 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 <strong>to</strong> its s<strong>to</strong>ckholders. However, for many fast growing startups, the C Corp is popular because it can offer s<strong>to</strong>ck in exchange for an ownership stake. HOW TO PAY YOURSELF Now that you know about the different business entities, it’s time <strong>to</strong> 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 <strong>to</strong> withholding taxes, which are taken each pay period. A withholding tax is a pay-as-you-go tax <strong>to</strong> the IRS and can be calculated through the W-4 and their IRS withholding calcula<strong>to</strong>r. 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 <strong>to</strong> be W-2 employees. The inverse is also true though. Some business owners who want <strong>to</strong> 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” <strong>to</strong> avoid paying withholding taxes. Business owners can also receive a dividend. Dividends are not taxed if it is a return of capital <strong>to</strong> the shareholder. Most dividends are paid out in cash, but you can also have a dividend of s<strong>to</strong>ck or other assets. Some owners may choose <strong>to</strong> 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 <strong>to</strong> capital, payment of wages, or other payment, depending on the substance of the transaction. Finally, a business owner can choose <strong>to</strong> do an owner’s draw. Unlike W-2 wages, a draw is not taxed at the company level. If you are a sole proprie<strong>to</strong>r or a partner in a partnership, your income is a draw. However, it’s also possible <strong>to</strong> do an owner’s draw as an LLC or even an S-Corp. 14 | <strong>Building</strong> <strong>Entrepreneur</strong>
Forming inspiring, personal relationships A partnership, like a building, is more than the sum of its parts. And both require true collaboration <strong>to</strong> grow. At Pepper, we’re always looking for responsive partners. Because we believe the relationships formed at the start of a project determine how it will finish. pepperconstruction.com 312.266.4700
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