Paying yourself when you are self-employed is not always a simple affair. Staying on the right side of the tax laws means you can’t always just have someone write you a check, deposit in your bank account and be done with it. When you decided to head out on your own, at least one of the motivating factors had to be about putting money in your pocket, but who knew it would be so complicated?
Options for Paying Yourself
There are three basic options for paying yourself when you are self-employed depending on how your business is taxed.
- Salary: this is a fixed dollar amount paid at regular intervals for work completed, with federal, state and local taxes withheld
- Owner’s draw: a withdrawal of any amount of money from business funds, which can’t exceed the owner’s actual equity in the business
- Distribution: earnings by S Corporations that are paid out or “passed through” as dividends to shareholders and only taxed at the shareholder level
You can also pay yourself using a combination of methods. For example, you can both take a salary and pull money from your business equity as a distribution. Doing this does lead to more complicated taxes as the two types of income are treated very differently for tax purposes.
Business Structure and Payment Options
Selecting the right payment option starts with knowing what type of business structure you are operating within. There are four main types of businesses, each with some defining characteristics:
- Sole proprietorship: a business that is owned in its entirety by one person, and only one person, and defined by the law as legally being a single entity
- Partnership: a business with at least two people with shared ownership and equity, who divide the profits and losses of the business between them
- Limited liability company (LLC): a business structure that provides legal separation between the business entity and owner or owners which can be taxed as a sole proprietorship, partnership, or corporation
- Corporation: a business that usually has multiple owners or shareholders and is a legally separate entity from its owners
In addition to the above list, there are two types of corporations that effect the method chosen for paying yourself, S and C corporations. The biggest difference between the two is related to how they are taxed. You can learn more about S and C corporations, as well as other business structure options and which one might be right for you, in our previous blog post.
The approach you take to paying yourself depends at least in part on your business structure, as shown in the table below. It does also matter if you do “work” for the business, as opposed to simply owning a stake in it. If you actively work for the business, such as managing the day-to-day operations, financials, or delivering services directly to clients, you can receive multiple forms of compensation. For example, someone who both owns a corporation and does work for clients, could receive both distributions and a salary.
|Business Type||Method of Payment|
|Limited Liability Company||Draw/Distribution (if multiple owners)|
|S Corporation||Distribution & Salary (if the owner does work for the business)|
|C Corporation -Owner||Taxable dividends|
|C Corporation – Owner & Employee||Salary & taxable dividends|
How Much Should You Take
If paying yourself using the draw method, deciding how much money to take out of your business can be a tricky decision. You can draw as much as you want, as often as you want, as long as there are funds in the accounts. But remember, you need to be sure that there is enough money in the bank to cover all your business liabilities and maintain adequate cash flow.
The best way to know for certain how much money you can safely draw from your business is to have accurate and up-to-date financial records. This information, combined with the advice of a CPA specializing in small to mid-sized businesses, can help you make good decisions that will keep your business thriving.
The Right Accounting Partner in Central PA
If you are looking for help in deciding which self-employed pay option makes sense for you, give us a call. At Gift CPAs, we help small and mid-sized business owners across central PA make smart choices that help them grow their businesses. If you are just getting started and looking for advice on what type of business structure makes sense for you, or need help understanding your financials, we’d love to help. Contact us today to start the conversation.