For many entrepreneurs, understanding how and when to draw a paycheck or some type of compensation for all the work they do is difficult. As a business owner, you are not technically an employee, and therefore, there aren’t any set parameters suggesting when and how much you should be paid.
Below we’ll explore some of the most common solutions to this problem, as well as answer questions regarding payroll taxes and the best way to pay partners.
Determining How Much to Pay Yourself
It might seem selfish to take the hard-earned money your business has generated and put it in your own pocket. Many business owners simply don’t pay themselves, because they’d rather reinvest in the business. This, however, is a bad practice.
First, you need to pay yourself if for no other reason than you need to pay your bills. Even with savings, there will come a time when that money runs out, perhaps even from an unforeseen business or personal expense that depletes your nest egg.
Secondly, if you never draw a paycheck from your business’ revenue, then you have an incomplete picture of what it truly costs to run your business. Thirdly, at some point, you’re going to want to get paid. Setting a precedent of not receiving a paycheck or salary might be a hard trend to reverse.
Here are a few things to consider when you’re trying to determine how much to pay yourself, as well as a few details to take note of when disbursing your compensation.
1. Requirements Vary Depending on Your Business’ Legal Structure
If you are a sole proprietor, you’re not considered an employee, so you won’t receive a paycheck or have FICA or state or federal income taxes deducted. Instead, you will take your “pay” from a distribution from the business’ profits, often called a “draw.”
If you are in a partnership, your salary would also come from the business’ profits. The amount of money and the way it will be distributed should be dependent on the language in the partnership or LLC operating agreement.
LLC owners—also called “members”—are not considered employees and don’t receive a salary. In fact, single-member LLC owners are treated like sole proprietors for tax purposes, while multiple-member LLC members are treated like partners in a partnership.
An owner of a C-corporation or an S-corporation is considered a shareholder. If the owner also works as a corporate officer, however, then he or she is entitled to a salary, including the necessary employment tax deductions. Shareholders are also allowed to take distributions of the business’ profits as part of their compensation.
2. You Won’t Receive a Standard Paycheck
Unless you own a corporation and work as one of its officers, the compensation you receive as a business owner won’t be in the form of a standard paycheck. Instead, you will draw your pay from a distribution of the business’ profits.
You also won’t receive a standard paycheck if you’re part of a partnership or a member of a multiple-member LLC. Instead, you will receive guaranteed payments from the LLC, which are deducted from the LLC or partnerships’ earnings as an expense, thereby lowering its net profits. Be aware, however, that guaranteed payments are still not considered taxable income like a standard salary, the latter of which would be subject to payroll withholdings.
3. There Is No Magic Number
Many business owners choose to pay themselves with a percentage of the business’ profits. An easy way to calculate this figure is to forecast your business’ income over the next six months to a year, then factor in all of your fixed costs, such as operating expenses, salaries for other employees, etc.
You also want to be sure you’ve set aside the appropriate amount of funds required to pay any business taxes or license fees. Once you’ve taken all of these expenses into consideration, you should be left with a percentage of your monthly profits that you can treat as your salary.
It’s also possible to reverse engineer this figure; that is, determine what you need to live your life modestly, but comfortably, and use that as your salary.
A quick note: the IRS has a provision that business owners must pay themselves a reasonable salary. The last thing you want to do is draw attention to yourself come tax time and possibly be on the receiving end of an audit. Use salary comparison websites to get an idea of what someone in your area makes doing a similar job.
4. You Still Need to Pay Taxes
Even though you won’t be required to pay standard payroll taxes when you draw the salary from your company’s funds, taxes are still owed on that money. As a sole proprietor, you will primarily use Form 1040, Schedule C (PDF) to report your business’ profits and losses as well as Form 1040 ES (PDF) to report any of your non-taxable income.
You will more than likely need to pay estimated quarterly taxes. These estimated amounts are paid to the IRS about every three months. At the end of the year, when filing your tax return, you will report your actual income. If it’s determined that you overpaid your quarterly taxes, you will be eligible for a refund.
5. Paying Taxes as a Partner is Slightly Trickier
If you are part of a multiple-member LLC, each member must pay their own applicable income tax on income received by the LLC. For a federal return, your LLC will file as a general partnership with Form 1065, and each member will receive its own individual Schedule K-1, which is to be reported by the partnership to the business’ partners and the IRS. Partners will use the information they find on their Schedule K-1 to complete their individual taxes.
The importance of paying yourself—and doing it fairly as a business owner—might be one of the hardest lessons to learn when you’re starting out. Start with putting a dollar amount on the value to your company. This will help you to understand how much work you really do, as well as give you an idea of how much your business has grown.