Many small business owners ask, “Should I put myself on the payroll?” The answer isn’t simple.

Whether you are looking to maximize your qualified business income (QBI) deduction or take advantage of employee fringe benefits, incorrectly paying yourself wages can cause serious issues.

In this article, we walk through the different ways the tax code allows you to pay yourself from your business, depending on your entity structure.

Background

Some of the confusion around how to properly pay yourself from your own business stems from our two-track system of collecting taxes to pay for old-age, survivor, and disability benefits (Social Security) and hospital insurance benefits (Medicare).

The Federal Insurance Contribution Act (FICA)¹ governs the collection of Social Security and Medicare taxes from employees and employers, while the Self- Employment Contribution Act (SECA)² governs the collection of similar taxes from self-employed individuals.

Under FICA, the employee and employer each pay a 6.2 percent Social Security tax and a 1.45 percent Medicare tax (15.3 percent total), while self-employed individuals pay the total 15.3 percent on defined self-employment income under SECA.

Although FICA taxes and SECA taxes are virtually identical, the classification as employee versus self-employed individual is important, especially when it comes to paying yourself.

The question you then need to ask yourself is, “Am I an employee or am I self-employed?” The answer depends on your entity structure.

Sole Proprietor

If you run your business as a sole proprietor, SECA rules apply.³ Since you’re not an employee, you cannot technically put yourself on the payroll.⁴ You report your net earnings on Schedule C of Form 1040 and pay self-employment taxes.⁵

How to pay yourself. Owner’s draw. You take money from your business when you want it.

Single-Member LLC

If you operate your business through a single-member limited liability company (LLC) without opting for taxation as a corporation, the tax code treats your LLC as a disregarded entity.⁶ In other words, your single-member LLC is a sole proprietorship for federal income tax purposes. You (remember, the LLC is disregarded) report your net earnings on Schedule C of your Form 1040, and you pay self-employment tax on your defined self-employment income.⁷

How to pay yourself. Owner’s draw. You take money from your business when you want it.

Partnership

If you are a partner in a partnership or a member of a multimember 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.⁸ As a partner or member actively engaged in the partnership or LLC, your earnings are subject to self-employment taxes.⁹

It is a common mistake for partnerships to keep partners on salary, especially new partners who previously received W-2 income. This is not correct.

How partnership operations work for your personal tax purposes:

• Guaranteed payments (for services performed) are reported by the partnership 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. For general partners, the profits are subject to both income and self-employment taxes. Passive limited partners do not pay self-employment taxes.

How you get the cash. Guaranteed payments generally come to you as cash. Profits are often distributed by the partnership to the partners following 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 probably already know that your net earnings aren’t subject to self-employment tax.¹⁰ Because the term “net earnings from self-employment” does not include flow-through income from an S corporation,¹¹ you may wish to pick this structure to save on self-employment taxes.

But officers of a corporation, including S corporations, are employees subject to FICA.¹² Because FICA defines wages as “all remuneration for employment,”¹³ the IRS takes the position that profit distributions paid to shareholders may be reclassified as reasonable compensation for their services.¹⁴

How to pay yourself:

• Reasonable compensation on a W-2
• Shareholder distributions of previously taxed profits (profits taxed to you personally)

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.

How to pay yourself:

• Reasonable salary on a W-2
• Double-taxed shareholder dividends

Takeaways

Paying yourself from your business depends heavily on your entity structure and understanding the tax implications of your choice. Here are the key points to remember:

• Sole proprietors and single-member LLCs. Use an owner’s draw to take money from your business. You’ll pay self-employment taxes on net earnings reported on Schedule C.
• Partnerships. Partners cannot be employees. You receive partnership money and profits via guaranteed payments and profit distributions, both of which are generally subject to self-employment tax.
• S corporations. You must pay yourself a reasonable W-2 salary, subject to FICA taxes. In addition, you pay taxes on S corporation profits, but they are not subject to FICA taxes. The corporation can distribute the previously taxed profits to you tax-free.
• C corporations. Pay yourself through a reasonable W-2 salary and shareholder dividends, but be mindful of double taxation on those dividends.

At Provident CPAs, we specialize in helping clients adapt to changing economic conditions. Whether you’re a business owner or an individual looking to optimize your tax strategy, our team is here to guide you through the complexities of today’s tax landscape. Contact us today to learn more about how we can help you achieve financial independence, even in the face of economic uncertainty.

This post serves solely for informational purposes and should not be construed as legal, business, or tax advice. Individuals should seek guidance from their attorney, business advisor, or tax advisor regarding the matters discussed herein. Provident CPAs assumes no responsibility for actions taken based on the information provided in this post.