Boss, it's time to pay yourself!
An owner of a new company can rarely take money
out of the business. Any money made from sales generally has to
be poured back into the company in order for it to grow and prosper.
That's conventional small-business wisdom.
Conventional wisdom, however, never gets hungry
or has a mortgage payment due. But because you live in the real
world, eventually you're going to have to pay some bills. What are
the legalities and the practicalities of drawing money from your
In terms of tax consequences, it depends on
how your company is structured, says Michael Koppel of the accounting
firm Gray, Gray & Gray LLP, in Westwood, Mass. In "pass-through"
companies -- such as sole proprietorships, limited liability companies
and S corporations -- income to the business entity is not taxed.
Instead, it is passed through to the individual owner or owners
and taxed there.
In the case of S and C corporations, the owner
as an officer of the corporation can be paid in salary and in distribution.
(Distributions are profits passed onto you as a shareholder.) The
salary is subject to employment taxes, but distributions are not.
Below are the strategies recommended for drawing
income based on your company's legal structure. Remember -- these
are general guidelines. For advice specific to your situation, it's
best to check with your accountant or financial adviser:
Although few small businesses are C corporations, some do exist.
For those companies taxed on their income, it's beneficial to pay
as much compensation as possible as salary, says Jeff Pannell, a
partner and CPA with Clark Nuber, an accounting firm in Bellevue,
Wash. That reduces the company's tax burden -- it can deduct paying
you as CEO, but giving you a dividend is not tax deductible. The
downside for you personally: You'll be paying employment taxes on
There are no tax codes related to reasonable
or unreasonable compensation. So it's up to the individual Internal
Revenue Service agent to decide if what you're claiming on your
corporate or individual tax return makes sense.
It all comes down to what's reasonable. If you're
paid $200,000 in salary and your company's only posting $210,000
in profit, that may raise a few eyebrows -- and the specter of an
audit -- with the IRS.
In addition to those types of red flags, the
IRS will also seek comparisons -- how much do CEOs make in comparable
companies? The agency will look at salary surveys in your industry
to try and make an assessment of what's reasonable and what's off
Of course, as a small corporation, your aim
should be to avoid an IRS hearing. Pay yourself a salary that's
commensurate with industry standards and is in line with what your
company is making, Pannell says.
Another way to essentially get paid is through
fringe benefits such as health insurance premiums and direct reimbursement
of medical expenses. Your company can deduct the cost of these benefits
and they're not treated as taxable income on your tax return.
"Here, the situations are nearly reversed," Pannell says. "S Corporations
tend to want to undercompensate and have employees take more in
the way of distribution."
That's because compensation is subject to employment
tax. Distributions are not.
Again, being what the IRS deems "reasonable"
"If you're a lawyer and you take all your compensation
as distributions and don't take a salary, the IRS will decide that
you've disguised a salary as a distribution. They will recast it,"
says Mike Petrecca, tax and legal services partner with PricewaterhouseCoopers
in Columbus, Ohio. "On the other hand, if you're pulling down a
$100,000 salary and receive a distribution of $50,000, the IRS probably
won't say a word." That's because it's clear that you are receiving
a reasonable salary in addition to, rather than as a substitute
for, a distribution.
While nobody wants to raise the ire of the IRS,
the good news is that while you'll have to pay back taxes if the
IRS decides to reclassify distribution money as salary, you won't
be subject to penalties, Petrecca says.
LLCs, LLPs, and the Like
Small businesses that take on a structure such as a Limited Liability
Company (LLC) or a Limited Liability Partnership (LLP) are taxed
at the end of the road -- on a partnership tax return, for example.
They are called "pass-through" entities since the taxes are passed
along and are paid by the individual rather than the corporation.
Generally all income is subject to employment
taxes. However, like S Corporations, LLCs and LLPs can distribute
payments to their officers. Distributions are not subject to employment
taxes, Clark Nuber's Pannell says.
Of course, the same reasonable rule applies
here. If the IRS thinks you're trying to avoid employment taxes
by paying yourself in a distribution, it will call you on it, Pannell
"They'll come in and say, 'Jeff, are you the
acting president of the partnership and you're not receiving any
salary even though you're working full time?' " Pannell says. That's
going to raise a red flag, the CPA says.
Salary being equal, an officer of a C or S corporation
will pay less employment taxes than a member (officer) of an LLC
will. However you'll have to measure that tax benefit against the
other pro's and con's of the different corporate structures before
you settle on one.
No matter which structure you choose and no
matter how you choose to pay yourself, one thing is clear: one way
or another, you'll be paying the taxman.
Jenny C. McCune is a contributing
editor based in Montana