How to correctly pay yourself and take cash from your business

If you are a small business owner and want to know how to put yourself on the payroll, then this one is for you. Let’s understand the tax codes that allow you to pay yourself from your business, depending on your entity structure.

Background

The confusion about how to properly pay yourself from your own business arises from the two-track system of collecting taxes to pay for old age, survivor, disability, and hospital insurance benefits.

The Federal Insurance Contribution Act (FICA) governs the collection of Social Security and Medicare taxes from employees and employers. In contrast, the Self-Employment Contribution Act (SECA) governs the collection of similar taxes from self-employed individuals.

Under FICA, employees and employers pay 6.2 percent Social Security tax each day and a 1.45 percent Medicare tax, while self-employed individuals pay 15.3 percent on defined self-employment income under SECA.

FICA taxes and SECA taxes are virtually identical. The classification as an employee versus a self-employed individual is crucial when paying yourself. Now arises the question, “Am I an employee or self-employed?” The answer depends on your entity structure.

Sole proprietor

If you run your business as a sole proprietor, SECA rules apply. Since you are not an employee, you cannot technically put yourself on the payroll. You report your net earnings on Schedule C of Form 1040 and pay self-employment taxes.

Single-Member LLC

When you operate your business through a single-member limited liability company (LLC) without an option for taxation as a corporation, the tax code treats your LLC as a disregarded entity. Your single-member LLC is a sole proprietorship for federal income tax purposes. You report your net earnings on Schedule C of your Form 1040 and pay self-employment tax on your defined self-employment income.

Partnership

If you are a partner in a partnership or a member of a multi-member LLC taxed as a partnership, you receive your taxable earnings either as guaranteed payments or as your share of the partnership profits. You are not an employee of the partnership. Your earnings are subject to self-employment taxes as a partner or member actively engaged in the partnership or LLC.

Many partnerships keep partners on salary, and this is a common mistake, especially for new partners who previously received W-2 income.

How partnership operations work for your personal tax purposes:

The partnership reports guarantee payments to you, the partner, via Schedule K-1. These are subject to both income and self-employment taxes.
Partnership profits are reported by the partnership to you, a partner, via Schedule K-1. The profits are subject to income and self-employment taxes for general partners. Passive limited partners do not pay self-employment taxes.

How to get the cash: Guaranteed payments generally come to you as cash. The partnership distributes profits to the partners according to the terms of the partnership agreement. Partners can also take draws against their partner accounts.

S Corporation

If you operate your business as an S corporation, you know that your net earnings are not subject to self-employment tax. Because the term “net earnings from self-employment” does not include flow-through income from an S corporation, you may wish to pick this structure to save on self-employment taxes.

However, officers of a corporation, including S corporations, are employees subject to FICA. Because FICA defines wages as “all remuneration for employment,” the IRS takes the position that profit distribution paid to shareholders may be classified as reasonable compensation for their services.

You can pay yourself through reasonable compensation on a W-2 or shareholder distribution of previously taxed profits.

C Corporation

If you operate your business as a C corporation, the corporation pays the corporate income tax on its profits.

If you want this money, you suffer what is known as “double taxation.” This means that profits are taxed twice: first at the corporate level with a flat rate of 21 percent on corporate income, and then again at your individual level when you receive the profits as dividends.

You can pay a reasonable salary on a W-2 or double-taxed shareholder dividend.

BergerCPAFirst, with over 30+ years of experience, offers comprehensive tax preparation services for individuals and businesses nationwide. Our commitment is to provide personalized attention while ensuring compliance and maximising tax benefits. If you have any questions or would like to schedule a consultation, please call (201) 587-9200 or send us an inquiry.