Are You Paying Yourself Correctly?

As a new business owner, you have plenty to keep you up at night. But nothing is more stressful than bookkeeping woes. One of the most common errors in a small business relates to how the owner takes money out of the business. Owners need to be careful about how they pay themselves because it affects their books and their taxes. The owner payments are determined by business type. The next step is understanding the difference between the two most common forms of “owner salary.”

Business Owner Draw/Salary: C Corporation

Draws from a C Corporation are taken as dividends limited to net income and paid according to stock ownership. The earnings are subject to a flat 21% corporate tax rate and they are taxed again at the personal level. Dividends are not deductible inside the business, but they are subject to preferential tax rates on the owner’s personal tax return. To avoid double taxation, owners can take salary/bonus that is deductible at the corporate level and taxed as wages at the personal level. This is called “zeroing out the corporation.” Business owners of C Corporations are cautioned not to treat draws as a traditional salary. Positive cash flow is an essential requirement if you want to ensure the financial stability of your business.

Distributive Share: Partner, Multi-member LLC, S corporation owner

A business with multiple members/owners can also be taxed as a partnership or S corporation. Income, loss, deductions, and credits from these entities are allocated to owners based on their distributive share. These entities do not pay income tax directly and instead pass that activity out to the owners who report their share of the activity on their personal return.

The percentage of share is usually spelled out in a partnership agreement and always totals 100%. When no agreement exists, distributive shares correlate to each partner’s share of ownership. The calculations are based on the following factors:

  • Interests in the economic or taxable income of the partnership
  • Capital contribution
  • The rights of partners to partnerships assets should the company be sold or file for bankruptcy

The process for taking a distributive share requires an accounting of the total net income. That profit is then divided among the partners, according to their share or the partnership agreement.

The following table shows the best practices of how owners should pay themselves and how that pay relates to their tax return.

Business Type/Owner Status How to Pay Yourself Tax Return to File Subject to Self-employment Tax
Partner Distributive share Schedule K-1 for 1040 Yes
Sole Proprietor Draw Schedule C for 1040 Yes
Single-member LLC Draw Schedule C for 1040 Yes
Multiple-member LLC Distributive share Schedule K-1 for 1040 Yes
Corporate owner Dividends Dividend income on 1040 Not on dividends
S corporation owner Distributive share Schedule K-1 for 1040 No
Corporate/S corporate owner Paycheck W-2 income on 1040 FICA (employee)

Other Considerations: Characteristics of entity type

There are other factors to consider regarding entity type including flexibility, liability protection, tax benefits, and many others.

Professionals at Cordell, Neher & Company are happy to discuss owner wage, entity types, and any other accounting and tax concerns that you might have.

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