If you ask a tax advisor this question, you will probably get their favorite answer: “It depends.” They’ll tell you this because the structure of your business entity determines how income is reported for income tax, social security, and self-employment tax purposes.
Entities formed as sole proprietor LLCs take distributions from their business as cash flow allows. There are no reporting requirements for these distributions. Rather all business income and deductible expenses are reported on Schedule C. Self-employment tax is computed and paid with the filing of Schedule SE, along with Form 1040.
Members of partnership LLCs may also take distributions from the business as cash flow allows. These distributions are not taxable income to the partner but they are reported on the Schedule K-1 as part of the reconciliation of the respective partner’s capital account. Partnership LLCs with multiple owners report taxable income on Form 1065, Partnership Return of Income. Earnings from the business will then be considered self-employment income and self-employment tax will be calculated on Schedule SE I.
If the entity is formed as a corporation or LLC and elects to be taxed as an S-Corporation, the owners of the company pay themselves compensation similar to an employee. Payroll taxes are withheld from their pay and W-2s are filed with the Social Security Administration by the business. When it comes time to file taxes, the owner reports W-2 wages on their personal tax returns. S-Corporation owners may also take distributions, which are not taxable, however reasonable compensation must be paid first.
If an entity is formed as a corporation and does not elect to be taxed as an S-Corporation, it will be taxed as a C-Corporation. Owners/shareholders providing services to a C-Corporation are compensated through wages reported on W-2s. Distributions to the shareholders are taxable dividends and the corporation is required to file a 1099-DIV with the IRS, reporting such dividends. Most closely held businesses do not opt to be taxed as a C-Corporation due to the fact that earnings are taxed twice, once as income to the corporation and again as a dividend to the shareholder.
According to Lorilei J. Roberts, CPA, MSBA, CGMA, Tax Manager at PBMares, LLP, the most tax sensitive entity for compensation purposes is the S-Corporation.
“The tax code requires payment of "reasonable compensation" for the type of work that you’re doing for the company. As a guideline, the IRS suggests basing your own compensation on what you would compensate an outside person to perform your job. In the event of an IRS audit, distributions may be reclassified as wages and payroll taxes could be assessed if the examiner determines that insufficient wages were reported based on the services the owner provided to the company. It is recommended that business owners consult their tax advisor to determine the most appropriate compensation plan for their situation,” advises Roberts.
The funding source for a business may have certain “employment” and payment requirements for business owners as well. A ROBS (Rollover Business Startup) funded business will require the investor to be a W-2 employee of the business. A self-guided investment however, may require that the investor have no part in the day-to-day operations and ONLY takes a distribution.
As you can see, there is no simple answer to the “how should I pay myself” question. BKE recommends you consult with a tax professional to determine the best the legal structure for your situation.
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