Small business owners have a lot to think about-- usually their first thought is not how they will be paid. But this is an important step.
Small business owners juggle a lot of responsibilities and wear a lot of different hats. Getting your company off the ground, and making sure it stays there, requires a lot of decisions. One of which should be how you are compensated– how do small business owners get paid? Although it’s often the last thing people think of when starting a small company, it should be carefully considered early in the process to make sure you and your business can grow.
Will you wait for the business to show profits before you take any wages, or will you need to make sure you’re bringing in an income as the business grows? The way small business owners get paid can vary, depending on the needs of the business and the owner, and the tax implications the owner wants to incur. Depending on the structure of the organization, other factors may also come into play. It’s important to plan ahead to reap the best possible wage and tax benefits.
Understanding the different types of small business models and how they can be compensated can make it easier to choose the structure that works best for the owner and the business.
Small businesses often start as one-person enterprises. These sole proprietorships can vary; there are independent contractors, entrepreneurs, and more. Many sole proprietors don’t take a traditional salary, with taxes and FICA withdrawals made on a routine basis. Sole proprietors often take money out of the business as it becomes available: often on an intermittent basis rather than a routine paycheck. There are different ways they can take funds from the company.
Many sole proprietors don’t take a traditional salary, with taxes and FICA withdrawals made on a routine basis.
Taking Earnings as a Draw
Small business owners and sole proprietorships generally take what is called a “draw.” Owners draw funds from the business’ profits or assets, initially to reimburse them for any capital invested in the business. A small business owner who performs dog grooming services, for example, may invest in equipment, advertising, a website, and more to market their business. The draw reimburses them for that investment as the business begins to create revenue.
Once the initial investment is repaid, sole proprietors are still entitled to take a draw as their salary. Your business is most likely considered the same legal entity as you: if this is the case, you may take out as much of the business’ profits as you like.
Sole proprietors who take their wages in the form of a draw are taxed at the personal level. These small business owners and their companies are considered the same legal entity: owners report business income or losses from on their personal tax return. The IRS categorizes these businesses as “pass-through” entities because profits pass through the business and are taxed on a personal return.
In a partnership, more than one person invests in and/or works to keep the business afloat. Each partner may draw against the earnings and profits the business gains, but not necessarily in the same amount. A 50/50 partnership should see small business owners sharing profits equally, but a 70/30 partnership will see a larger share of the profits go to the owner who had the larger initial investment.
Partners that take a draw from the business are also taxed at a personal level because the partnership is considered a pass-through business.
LLC versus Sole Proprietorship
Many small business owners make the decision to become a corporation, often as an LLC, or Limited Liability Company. One of the main benefits of becoming an LLC is to protect the owner’s personal assets. The LLC separates the business assets (and potential risk, losses and/or damages) from the owner’s personal assets. If an LLC goes into bankruptcy, for example, creditors cannot assign the owner’s personal assets to be repaid.
The LLC separates the business assets from the owner’s personal assets. If an LLC goes into bankruptcy, for example, creditors cannot assign the owner’s personal assets to be repaid.
An LLC is structured similar to a corporation, but for tax purposes, works more like a sole proprietorship. Similar to a sole proprietor, owners generally take a draw from the company’s profits rather than a traditional paycheck.
Owners that take a draw from the LLC are taxed at a personal level as they would any other pass-through entity. If they opt for a salary, they will be responsible for all payroll taxes that would normally be due.
What is a dividend?
Dividends are another way small business owners can pay themselves. Dividends can be cash dispersals or can be paid in stocks or other assets. Dividends are not taxed if they are a repayment of capital to the owner of the business. For example, startup costs incurred to get the business rolling, or investments later on for equipment are all eligible to be reimbursed as a dividend that is non-taxable.
Owners can also take dividend payments as non-repayments on investment. These dividends may be taxable and business owners should consult with a qualified tax professional to assure they are reported and taxes are paid correctly for them.
For tax reasons, most small businesses, like LLCs, partnerships and sole proprietorships may be considered S Corporations (S Corps). This designation lowers tax liability considerably. Instead of filing a corporate tax return and paying tax on net profit or loss, S Corps don’t pay tax on the business profit, as it is reimbursed to the partner or owner, taxed at the income tax level. For small businesses that want to incorporate, and remain a pass-through entity, with all its tax benefits, becoming an S Corporation is a wise choice.
There are a variety of ways small business owners can earn wages from their company. The wisest choice is to consult a tax professional who can help you structure your company to the best possible tax advantage.
This article is for informational purposes and is not meant to provide legal, regulatory, accounting, or tax advice.