The form of ownership that you choose to operate your business under will determine the method in which you pay yourself a salary. Making this decision in the start up phase requires much research and should be handled with care. We choose our form of ownership, mainly based on the potential tax consequence that we expect. Of course, our goal is to pay as little taxes as possible into the system, so the form of ownership chosen helps to achieve this goal. There are clear advantages and disadvantages based on each method available.
As a small business, many people survive from the earnings from operations. But the key here is to remember to keep your business and personal expenses separate. So the questions is, “How do I pay myself, and what impact does it have on my taxes?” Let’s look at some of the ways a business owner can pay themselves a salary from the earnings of their business.
Sole Proprietors and LLCs
Taking money out your business or paying yourself under these forms of ownership, the owner will be responsible for self-employment taxes on any profits that remain in the business whether withdrawn or not. Because this income is not subject to withholding, the owner could also become responsible for making estimated quarterly tax payments. The estimated tax payments will account for both the self-employment tax along with income tax. The self-employment tax is the equivalent of what an employer’s payroll tax would be for FICA and Medicare. The disadvantage here would be that the owner is fully responsible for the entire tax, whereas corporations are not. The corporation is only responsible for half of the FICA taxes; Social Security (12.4%) and Medicare (2.9%) tax; with the employee paying the other half.
Many owners become confused because they believe that since they are paying the self employment tax, that they are not subject to any further taxation. This is not true. The money you withdraw from your business is still subject to income taxes and you must report this income on your form 1040. The key point to remember here is that, although you are not subject to payroll taxes, you are still required to pay into the system by way of self employment and income taxes. The advantage here is the owner gets a deduction on its taxes for paying self employment taxes, where the owner of a corporation doesn’t. For tax purposes you can elect to have your LLC taxed as a corporation, but be aware that making this choice involves very complex rules and regulations. It’s best to stick with what makes sense for you.
If you are established as this form of business, the payment to yourself would be made in the form of a salary through payroll. Under this method, you are subject to payroll taxes, which include income (federal and state), and FICA (Social Security and Medicare). One of the key advantages of corporations is that the owners are not liable for self-employment taxes for profits retained in the business. As with Sole Proprietorships and LLCs, you saw that profits are taxed whether paid out or retained in the business. However, a corporation will be subject to unemployment taxes for both federal and state. The employee does not share in this expense. So, the difference here comes in the classification of a corporation being an entity separate from its owners. Because of this, it has an entire different tax profile than the Sole Proprietor or the LLC. The corporation and its owners are taxed separately. Each must file its own tax form.
Deciding on your method of payment simply comes down to how it must be reported for tax purposes. Take the time to do the research so that you can choose the best method based on your company’s profile.