Are you a new business owner? You may be wondering how to pay yourself from your business. The answer depends on the way your business is set up. Here are common methods for making payments to business owners.
Corporations. If you own a traditional C corporation, your salary is subject to income and payroll taxes. Both are withheld from your paychecks, and your business must “match” the social security and Medicare portions and pay the taxes to the IRS. In addition, you might also choose to pay yourself dividends, which are usually taxed at preferential rates and exempt from payroll taxes.
If your business is an S corporation, you generally must pay yourself wages, and you also have the option of taking “draws.” Draws aren’t reduced by federal income tax withholding or payroll taxes, and may be considered a return of your investment in your business.
In either case, you’ll need to take a reasonable amount of compensation. Why? To avoid having your payments reclassified, resulting in additional tax and penalties. For example, if you take large draws and a small salary from your S corporation, the IRS can challenge your salary as being unreasonably low in an attempt to avoid payroll taxes. Similarly, salaries of C corporation owners may be deemed to be unreasonably high if the IRS suspects the motive is an attempt to maximize business deductions for wages.
Partners and sole proprietors. Generally, as a partner or sole proprietor, you’ll pay yourself from business earnings without withholding income or payroll taxes. If you’re an owner, or member, of a limited liability company, you’re typically paid and taxed in a similar manner as partners. Remember, even if the payments you take aren’t subject to withholding, you still may be required to pay quarterly installments of estimated tax. See the article Should You Be Making Estimated Tax Payments?
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