6 MIN READ
“I take money out of my business with draws...would it be better to pay myself?” This is a very common question asked by new business owners.
There are two questions I have to ask in response: 1) Why do you want to pay yourself, and 2) What type of tax entity is your business?
Generally, the first question is easier for new business owners to answer, but more on that later. (You’re an LLC, right? But are you really?)
In this post, I’ll go through some of the common reasons people want to “pay themselves”, and then I will outline how you accomplish that depending on the type of tax entity you are.
And before all of that, I’ll help you figure out what type of taxable entity your business is if you don’t already know. (Here’s a little hint: it’s not an LLC!)
Why do you want to get paid?
Is it because you just want money to go from your business account to your personal account (your business, your money, right?)? Or do you want a payroll expense deduction on your business’s books? Or do you simply want a consistent amount of money coming into your bank account every two weeks so you can work on your personal budget? Or maybe you don’t want your bookkeeper seeing every time you take a draw for personal expenses.
Next, what type of business entity are you?
If you just started a business and didn’t file any paperwork with your Secretary of State, you’re most likely a sole-proprietor (unless you have a business partner, then you’re a partnership). Or if you filed articles of incorporation with your Secretary of State, you’re clearly a corporation (and a C corporation at that, unless you made an S Election with the IRS).
Then there is the LLC. The LLC is a wonderful thing. They are easy to set up (unlike a corporation), they give your personal assets some protection from your business debts (unlike a sole-proprietor), and generally don’t require boards of directors, meetings, or minutes.
The other great thing about LLCs? They are state level legal entities that the IRS doesn’t recognize.
Wait, what? Yes, if you have an LLC, the IRS is going to tax it as something other than an LLC (way to go, IRS). I guess that isn’t necessarily a great thing about LLCs, but it is a thing.
However, as a tax practitioner, I love the flexibility of LLCs. LLCs are relatively new business entities. They originated in the 70s and started gaining popularity in the 90s. But you cannot file an LLC tax return with the IRS; there’s no such thing. If a CPA ever asks you what type of tax entity you have and you say LLC, it’s very likely you’ll see a head explode. For the most part it’s because an LLC could be taxed as just about anything.
Ok, so what IS your LLC?
I hate to do it, but I have to answer your question with a question. Ok, two questions.
Question 1: How many owners does the LLC have?
Question 2: Have you filed any paperwork with the IRS to tell them how you want to be taxed?
This is crazy talk, right? You can just tell the IRS what sort of entity you want to be? Yes, you absolutely can.
You do it with a Form 8832 which is commonly referred to as the “check the box” form. (Well, commonly within the tax professional community anyway.)
But after you check that box, it’s best to stick with the entity you chose. There are ways to change it, but you’d very likely end up paying a lot of fees to your CPA and probably even your lawyer. Therefore it’s important you consult with a CPA or a tax attorney to make sure you’re picking the right entity type for you and your business. Maybe even have a chat with your financial advisor, too, because that’s always a good idea when making decisions about your financial situation.
What’s that? You have an LLC, have had one for a few years, and file tax returns, but you never checked any boxes? This is also possible, and not uncommon.
The IRS has certain defaults for LLCs that otherwise stay silent on their entity choice. An LLC with one owner is referred to as a “disregarded entity” and its income and expenses are reported on the owner’s Form 1040, Schedule C. If the LLC has more than one owner, it is treated as a partnership and its income and expenses are reported on a Form 1065.
So, basically your LLC can be treated as a Schedule C business, a partnership, an S Corporation, or a C Corporation. However, if your LLC only has one owner it cannot be treated as a partnership, and if your LLC has more than one owner it cannot be treated as a Schedule C business. (There are a few exceptions for community property states, but we’re not getting into that here.)
And now, after all that, you still might not know what type of taxable entity your LLC is. If you have already filed a tax return that reported your business income, look to see what form you filed, and that will give you the answer you’re looking for.
Schedule C Entity – You don’t have any choice on how you get paid—it’s all through distributions or draws, whichever term you’d like to use (they’re synonymous).
While you can, of course, have employees and payroll, you cannot put yourself on payroll or give yourself a W-2.
You can, however, decide to take a standard distribution every two weeks, provided your business has the cash flow to support that. Your distributions, however, will never be a business expense. But conversely, these distributions do not get taxed twice like dividends do in C corps.
Partnership, Form 1065 – Similar to a Schedule C business, you can have employees and payroll, but the partners (aka LLC members) cannot be on payroll or get a W-2. You can take distributions as you’d like and if you have the cash flow to support, or you can take guaranteed payments.
The difference in distributions and guaranteed payments is what the payment is for and if the payment or amount of payment is made without regard to the partnership’s profits. Think of guaranteed payments as salary-esque; they are paid to a partner for services rendered to the partnership or use of the partner’s capital. And LLC member manager gets a guaranteed payment of $5,000 every month for the services they provide running the company, for example.
S Corporation, Form 1120S – As with Schedule C’s and partnerships, S corporation shareholders can take distribution. But be careful here. If there is more than one owner, a shareholder cannot get a distribution unless all shareholders get a distribution in the same ratio as ownership.
For example, if Mike and Betty own an LLC that is treated as an S corporation for tax purposes, and Mike owns 30% while Betty owns 70%, for every $100 that gets distributed, Mike gets $30 and Betty gets $70.
Additionally, if you are an owner in an S corporation and you work for that S corporation, you have to be on payroll, even if you’re the only owner.
Unlike distributions, however, shareholders’ salaries do not need to reflect their ownership percentage. Continuing with Mike and Betty, Mike can have an annual salary of $50K while Betty has an annual salary of $20K if that’s what they agree to (perhaps it’s a CPA firm and Betty only works during tax season). However, you are required to take “reasonable compensation”; this is the IRS’s way of making sure you don’t pay too little Social Security and Medicare tax.
C Corporation, Form 1120 – If you work for your C corporation, you can take a salary, and probably should—you work hard and deserve a paycheck! Or you can take a dividend. Your C corporation does get to take your salary as a deduction, but dividends are not tax deductible. C corporations are allowed to have difference classes of stock (S corporations are not), so you don’t necessarily have to give dividends to every shareholder (think about common vs preferred stock).
So there you have it: those are the ways to get paid or take money out of your business. It’s important to note that your business earnings will always be subject to income tax. There’s really no way around that; different entities just have different ways of paying that tax. Whether you are on payroll or take draws/distributions, the IRS is going to get their cut.
There are tax advantages and disadvantages to each entity type and each method of taking money out of your business. If you plan for it, there is a lot of potential to save yourself some income tax and even some self-employment tax. Of course consult with a CPA or tax attorney (and your financial advisor!) before you make any final decisions, because like I said, you will be stuck with it for a while!
About the Author
Jason Brown, XY Tax Solutions’ Senior Tax Manager, is nerdy even among CPAs. He enjoys tax research and doesn’t mind spending a nice evening at home with the Internal Revenue Code. Perhaps that’s a bit of a stretch, but he certainly spends a fair amount of time reading federal and state tax laws, and even the occasional court case. While knowing tax laws for the sake of knowing them is reward enough itself, he also finds job satisfaction in being able to interpret tax rules and regulations for clients in a practical, meaningful way in an attempt to help clients shift their tax mindset from a once-a-year splitting headache to a proactive and strategic approach.