Paying oneself as the owner of a limited liability company (LLC) or single proprietor is quite simple, but it becomes a little more complicated when you become an S Corp.
For example, if you accept an insufficient wage or do not take a salary at all, you may face IRS inspection, fines, penalties, and interest.
An S Corporation allows business owners to pay themselves in three ways: dividends, salary, or a combination of the two. How much money you give to the company and how well it does financially both have a significant impact on which option is best. Let us investigate more.
why are S Corp. payment structures different from other business models?
The unique payment structure of an S company allows firms to protect themselves from liability while maximizing tax benefits.
In other words, unlike a partnership or sole proprietorship, an S-corp owner and shareholders are not personally liable for the company’s debts. That is, if your firm is sued or unable to pay its creditors, your personal assets are safeguarded.
Filing as an S Corporation also provides numerous tax advantages. For one thing, you can enjoy the benefits of incorporation without the double taxation that C corporations face.
Corporate profits and losses are distributed to shareholders in an S Corporation, just like in a partnership or an LLC. As a result, corporation taxation does not apply to business income; shareholders pay taxes on those profits when they file their personal income taxes.
Furthermore, although sole proprietors, LLCs, and partnerships pay self-employment taxes on their whole business revenues, S Corporations only pay self-employment taxes on their wages.
All other income is distributed to shareholders. The S-Corp structure is famous among small business owners since these payouts are not subject to self-employment tax.
If you’re asking why S Corp owners don’t just take zero pay to avoid self-employment taxes entirely, there is a hitch. Suppose you are both a shareholder and an employee of a corporation (as most small business shareholders are).
In that case, the IRS requires you to pay yourself a “reasonable salary” before getting a tax-free payout.
related: annual budgeting guide for startups
what is a “reasonable salary”?
The general criteria for determining your compensation is that it must be “reasonable.” According to the IRS, “reasonable pay is “an amount that would ordinarily be paid for services by organizations under similar circumstances.”
In a nutshell, pay yourself a salary comparable to what firms in the same industry pay for comparable work and experience.
Here are a few other things to think about when deciding on a wage that is both comfortable for you and acceptable to the IRS:
- Your credentials and related training
- The number of years of experience you have
- Your industry and the breadth of your work
- The size and type of business you run
- The income of others in similar roles
- Location and living expenses
All of this is to imply that if you want to compute your compensation, you should first do your homework. There is industry information and tools available to assist you in determining the best amount for you.
Check out the Bureau of Labor Statistics and RCReports, as well as job-review websites such as Glassdoor, Salary.com, LinkedIn Salary, and PayScale.
read more on: the 14 must-have startup tools
you can pay yourself in three ways: salary, distributions, or both
Owners of S Corporations who manage business operations have two roles: shareholder and employee. On the other hand, owners who do not handle day-to-day activities are just considered shareholders.
In an S-corp structure, your role directly affects your pay. Earnings can be collected in three ways:
- A wage for an employee
- Dividends to shareholders
- a combination of the two
option 1: pay yourself a wage as if you were an employee
If you perform employee-like duties for your company, you must be paid on a W-2 basis in order to report and pay employment taxes correctly. This is an IRS requirement regardless of whether you get remuneration as a shareholder, such as distributions (more on that later).
There are numerous benefits to paying yourself a predetermined wage. You know exactly how much company money is paid to you each month instead of taking it from the business account every time you need money.
This makes managing cash flow and tracking spending easier. Earning a salary demonstrates a consistent source of income (which is essential when applying for a mortgage or anything credit-related).
As previously stated, S-corp employees must be paid a reasonable wage that is equal to a salary offered by similar businesses for the same experience but not so low that you avoid paying certain taxes.
Suppose the IRS concludes that a shareholder’s compensation does not meet “reasonable compensation” standards. In that case, the S Corp. owners can be penalized for failing to withhold and deposit employment taxes, as well as for back taxes owed.
one final point about S Corp. salary
It’s a good idea to have any documentation or data you used to calculate your compensation number on hand in case the IRS audits you.
option 2: take shareholder distributions for yourself
Suppose you are not involved in your firm’s day-to-day operations and do not provide services to the S Corporation. In that case, you can receive money from the company through shareholder dividends rather than a salary.
A distribution is a payment of earnings to shareholders, typically in cash or stock, that is taxed at the shareholder level. Distributions, unlike salaries, are not subject to payroll, employment, Social Security, or Medicare taxes. They are instead taxed on the shareholder’s personal income tax return.
Taking distributions gives you additional wage flexibility, allowing you to change your income based on your firm’s profitability.
You don’t have to pay taxes on shareholder distributions until you exceed your stock basis—the amount of money you first put into the company. Once you’ve exceeded that limit, you’re required to pay.
Unlike a C corporation’s stock basis, which remains constant year after year, an S Corporation’s stock basis might fluctuate due to business gains and losses.
That is why you must track your stock basis regularly so that you can appropriately declare your distributive shares of profit and loss on your personal income tax returns.
option 3: pay yourself a salary and make distributions to yourself
As an owner and shareholder-employee, you can pay yourself through a combination of dividends and salaries as long as your income is commensurate with the work you do. Additional profits can be distributed as distributions, which result in a decreased tax payment.
Here’s an illustration: You make a net income of $160,000 annually. Because of your responsibilities, you are entitled to $60,000 in salary and $100,000 in distributions.
Distributions are not subject to employment taxes as long as your pay fits the reasonable compensation requirements. If you fail to follow the guidelines, the IRS may categorize your other income as taxable income.
Before pursuing this option, it’s always a good idea to speak with a chartered professional accountant (CPA) to learn more about what constitutes a sufficient income in your state.
how countick can assist
We can manage your bookkeeping and tax filing while you focus on your business as America’s leading professional bookkeeping service for small businesses.
If you don’t know how to manage to pay yourself when you create (or switch to) an S Corp, you may end up with accounting mistakes that lead to significant tax difficulties later. Your Countick bookkeeping staff will keep your finances up-to-date so that you can make informed decisions and meet any new regulations.
We’ll walk you through what a structure change means for your firm and how to keep your books up to IRS standards. With our tax
filing solution, you’ll get year-round tax advice as well as an all-star team to prepare and file your tax return.
read more on: how does the irs get people to pay the taxes they owe
pay yourself fairly
S Corporations might be an intelligent method to save money on business taxes, particularly when it comes to paying yourself. The ultimate goal, at the end of the day, is to pay your tax obligations while also being paid what you’re worth.
However, making that decision is dependent on several things. Make sure to examine your individual demands and choose what is best for your personal and business situations. Once you’ve got that down, you can move on to the other duties that will help your firm flourish.
