How to Pay Yourself: Shareholder Salary Vs. Dividends or Distributions
Business Owners: How Are You Paying Yourselves?
Business owners need to understand the tax implications of how they draw income from their businesses. This is a complex topic, but let’s start with a quick overview of options.
Sole proprietors are not considered employees and get paid by drawing money from the business. No FICA taxes are taken from these draws, but sole proprietors will pay self-employment taxes on their individual tax returns on the income generated by the business.
A partner takes distributions from the profits in a partnership. A partner’s share of the profits will flow through to the partner on a K-1 which will then be reported on their individual income tax return. Some partners may receive a guaranteed payment, which is similar to a salary and is subject to self-employment taxes.
If you own an LLC, you do not take a salary but instead take a draw, similar to a sole proprietor.
You have more freedom in deciding when you take distributions from the company with all of these options, but it also necessitates the need for careful tax planning. Often business owners will pay quarterly tax estimates to avoid large balances due and/or underpayment penalties on their individual tax returns which occur if taxes are not paid in throughout the year. It is best if you have a personal tax planning strategy to help minimize your tax burden as much as possible.
Where Things Get More Complex is When Your Business is Structured as an S or C Corporation
There are three ways to receive payment from a corporation:
Receiving a salary
Obtaining a shareholder loan, which is required to be repaid
As a business owner in an S corporation, who is involved in the day-to-day operations, the IRS says you are required to take a salary and pay the required employment taxes on that salary. These taxes include FICA payroll taxes and federal unemployment taxes.
It might seem enticing to take a lesser salary to reduce the amount of employment taxation required, but the IRS has rules on how much corporate owners must be paid. According to the IRS Reasonable Compensation Guidelines, the key to establishing reasonable compensation is determining what the shareholder-employee did for the S corporation using these factors:
Training and experience
Duties and responsibilities
Time and effort devoted to the business
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
The use of a formula for determining compensation
Amounts paid out as salary compared with the amount distributed as profits
If you underpay yourself, you could face IRS fines. But if you overpay your salary, you may be paying more taxes than you need to. Be sure to review the IRS Reasonable Compensation Rules to guide you in determining your salary.
Distributions/Dividends – S Corporation vs. C Corporation
In an S corporation structure, you can also distribute profits from the business, which avoids employment taxation. S corporations are subject to single-level taxation. Income generated by the corporation is typically not taxed at the corporate level. It is distributed among the shareholders and reported on individual tax returns for payment of tax due on their share of the S corporation's earnings. Since an S corporation distributes income as single-level taxation, it will not be taxed a second time.
The taxable income earned by a C corporation is first taxed at the corporate level. When the income is distributed to its shareholders, it is generally taxed as a dividend. This results in the same income earned by the corporation being taxed twice (double taxation), once at the entity level and again at the shareholder level.
The tax implications noted above should be reviewed with your accountant as you determine if your business should be an S or C corporation. The double taxation noted above may not be as big of a concern now that there is a 21% flat income tax rate for C corporations. (Note the top individual income tax rate is currently 37%). S corporations may be able to take advantage of the Qualified Business Income (QBI) 20% deduction.
There may be a time when you want to take a loan from the company for a larger expense. If there is extra cash in the business, this can be a convenient option. However, it must be treated as a loan. You will want to be sure the IRS won’t claim that the shareholder received a taxable dividend or compensation, rather than a loan. The IRS considers the following factors when deciding if it is a bona fide loan:
The size of the loan
The company’s earnings and dividend-paying history
Provisions in the shareholders’ agreement about limits on amounts that can be advanced to owners
Loan repayment history
The shareholder’s ability to repay the loan based on his or her annual compensation
The shareholder’s level of control over the company’s decision making
If there is a written formal payment terms agreement and schedule
Summary and Additional Resources
The decision on how to pay yourself may change over the life of the business. Work with an experienced accounting firm to model out the option that affords you the best tax-advantaged way to draw your business income. This is not a one-and-done exercise. Compensation should be reviewed every couple of years to ensure the plan still fits your personal and business needs.
Holly is a Senior Manager with SVA Certified Public Accountants and specializes in individual taxation with a focus on proactive tax planning and developing strategies to minimize current and future tax liabilities.