What Is It Called When You Pay Yourself From Your Business?

When a business owner takes money from their company, the process differs significantly from how an employee receives a paycheck. An owner’s compensation method is linked to the legal structure of their business, impacting how funds are transferred and their financial and tax implications. Understanding these methods is important for proper financial management and compliance.

Owner’s Draws and Guaranteed Payments

Owners of certain business structures commonly compensate themselves through either owner’s draws or guaranteed payments. An owner’s draw is a common method for sole proprietorships and limited liability companies (LLCs) that are taxed as sole proprietorships. This involves directly taking funds from the business for personal use.

An owner’s draw is not considered a business expense and therefore is not deductible from the business’s income for tax purposes. These funds are also not subject to payroll taxes at the time they are taken from the business. Instead, an owner’s draw reduces the owner’s equity within the business. The owner’s entire profit from the business is taxed at their individual income tax rate, regardless of whether those profits are taken out as a draw or left in the business.

Guaranteed payments, on the other hand, are typically used by partners in a partnership or members of an LLC taxed as a partnership. These payments are regular amounts made to partners for services they render to the partnership or for the use of their capital. Unlike draws, guaranteed payments are made irrespective of the partnership’s overall profitability.

For tax purposes, guaranteed payments are considered taxable income to the individual partner receiving them. From the partnership’s perspective, these payments are generally treated as a deductible business expense, reducing the partnership’s taxable income.

For both owner’s draws and guaranteed payments, owners are responsible for self-employment tax. This tax covers Social Security and Medicare contributions, which are typically split between employees and employers in a traditional employment setting. Owners pay the full amount of both portions, totaling 15.3% on net earnings from self-employment up to certain income thresholds for Social Security, plus 2.9% for Medicare on all net earnings.

Owner Salaries and Distributions

Owners of S Corporations, including LLCs that have elected to be taxed as S Corporations, use a two-part compensation method involving a salary and distributions. For owners who actively work in their S-corporation, the Internal Revenue Service (IRS) requires them to be paid a “reasonable salary.” This salary must be comparable to what a non-owner would earn for performing similar duties.

Ensuring a reasonable salary is important for IRS compliance, as failure to do so can lead to reclassification of distributions as wages, incurring additional taxes and penalties. This salary is subject to regular payroll taxes, including Federal Insurance Contributions Act (FICA) taxes for Social Security and Medicare, Federal Unemployment Tax Act (FUTA) taxes, and State Unemployment Tax Act (SUTA) taxes. Both the employee and employer portions of these taxes must be paid, with the S-corporation responsible for withholding the employee’s share and paying its own employer share. The salary paid to the owner is a deductible business expense for the S-corporation, reducing the company’s taxable income.

After paying a reasonable salary to the owner, any remaining profits within the S-corporation can be distributed to the owner(s) as owner distributions. These distributions are generally not subject to self-employment tax or payroll taxes. They are considered tax-free to the owner up to their basis in the company, which represents their investment in the business and accumulated profits.

The salary component is subject to payroll taxes and is deductible by the business, while the distribution component, after the salary, is typically not subject to payroll taxes and is often tax-free to the owner up to their basis. This structure allows S-corporation owners to potentially reduce their overall self-employment tax burden compared to sole proprietorships or partnerships, provided the reasonable salary requirement is met.

Owner Salaries and Dividends

For owners of C Corporations, including LLCs that have elected to be taxed as C Corporations, owner compensation typically involves a salary and, potentially, dividends. If a C-corporation owner actively works for the business, they are generally paid a salary, much like any other employee. This salary is subject to all applicable payroll taxes, including FICA, FUTA, and SUTA, with both employee and employer portions being remitted.

The salary paid to the owner is considered a deductible business expense for the C-corporation. This deduction reduces the corporation’s taxable income. However, after salaries and other business expenses are paid, any remaining corporate profits are taxed at the corporate income tax rate.

If these after-tax profits are subsequently distributed to shareholders, including the owner, in the form of dividends, those dividends are then taxed again at the individual shareholder level. This phenomenon is commonly referred to as “double taxation.” The corporation pays tax on its profits, and then the shareholders pay tax on the dividends they receive from those already-taxed profits.

Unlike S-corporation distributions, which are generally tax-free up to the owner’s basis, C-corporation dividends are typically taxable income to the shareholder. This distinction is a factor in choosing a business structure, as the double taxation of C-corporation profits distributed as dividends can lead to a higher overall tax burden for the owner compared to other entity types.