How do I pay myself as the owner of a small business?
My name is Lori Thompson and I am the owner of Professional Accounting Services and the H&R Block Business Office here in New Lenox. We moved to New Lenox just over eight years ago from the Beverly area in south Chicago, and have really enjoyed meeting so many wonderful new people and watching our community grow.
I am excited to get started blogging. I have owned successful small businesses on and off (mostly on) for the last twenty-two years and have made all the same mistakes over the years as most new entreprenuers make.
Experience helps, but so does education, and I spent a great deal of time trying to figure out how to untangle myself from situations that could have been avoided had I done some research, or consulted a professional, instead of listening to unqualified opinions about how I should be running my business. I am sure you have a few acquaintences like that too.
Now, with the help of the internet, we have all this information right at our fingertips, which makes researching business rules and regulations so much easier. It also means there is really no excuse for business owners to make those serious mistakes that can cost them alot of time and money to fix. At least that is how my friends at the IRS see things...
Anyway, I have a great deal of important information to share with you. Information that I hope you will find useful in your lives and your businesses - tax tips, small business tips, regulations to stay compliant, and much more.
We also share these tips and ideas in our monthly small business workshops, which you can find listed under events on the Patch. Topics range from taxes, to insurance, to human resource issues, and much more.
So lets get started...
Today's topic is "How do I pay myself as the owner of a small business?"
This has to be one of the most confusing concepts to new small business owners that we work with. It is so important that you pay yourself correctly or you could find yourself in a world of trouble with not only the IRS, but the Illinois Department of Revenue and the Illinois Department of Employment Security. And the state agencies can be ruthless in thier penalty and interest policies.
The IRS has specific rules that address how you, as the owner of your business, should pay yourself. Those rules are different depending upon the type of business structure (form of entity) you choose to set up. Of course, you can find detailed information on the IRS website, but I will cover the highlights from thier website here.
According to the IRS, "An officer of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee." You can find more information on this in "Who Are Employees?" in Pub 15-A, Employer's Supplemental Tax Guide, on the IRS website.
Partners are not employees and should not be issued a Form W-2. Partners each receive a Schedule K-1 for thier share of distributions or guaranteed payments from the partnership.
For example, you fall into this category if you are a multiple member LLC and each member takes a guaranteed payment as compensation. Each member would receive a Schedule K-1 when the business tax return is completed. But LLC's can get tricky, so talk to a professional about your specific LLC. Single member LLC owners typically do not receive a Schedule K-1 and may follow the tax rules of a sole-proprietor using Schedule C, unless the owner chooses that the business be taxed like an S Corp.
Again, make a phone call to an accountant, tax professional, or lawyer if you are not sure how your business is set up, especially if you set it up yourself. You may not have set up the company correctly with the state (Am I a member-member or a manager-member?) or sent in all the appropriate tax forms (What are forms 2553 and 8832 anyway?).
The IRS says that "Any distribution to shareholders from earnings and profits is generally a dividend. However, a distribution is not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in money, but they may also be in stock or other property. For information on shareholder reporting of dividends and other distributions, refer to Publication 550, Investment Income and Expenses on the IRS website".
Form 1099-MISC or Form W-2
The IRS is very strict on how you classify your employees and subcontractors. If you mistakely classify a service provider as a contractor that should have been on your payroll, you could be liable for all those unpaid taxes, penalties and interest.
If you are an independent contractor or business owner that provides services to others, you are typically considered self-employed and therefore would receive a 1099 for your services. If you hire services from others, you must determine if they should be classified as a subcontractor or an employee. We can get into the rules on classification in another blog, but if the suspense is killing you then you can find those rules on the IRS website under Independent Contractor.
The IRS states "You cannot designate a worker, including yourself, as an employee or independent contractor solely by the issuance of Form W-2 or Form 1099-MISC. It does not matter whether the person works full time or part time. You use Form 1099-MISC, Miscellaneous Form to report payments to others who are not your employees. You use Form W-2 to report wages, car allowance, and other compensation for employees."
Treating employees as nonemployees
Again, the IRS says that you will be held liable for all social security and Medicare taxes and withheld income tax if you do not deduct and withhold these funds because you treat an employee as a nonemployee. This goes for you too as the owner, so if you are supposed to pay yourself through payroll and are issuing yourself a 1099, if you are a corporate officer, then you may be liable for a trust fund recovery penalty. Publication 15, Circular E, Employer's Tax Guide lists more information regarding the trust fund recovery penalty.
Shareholder loan or officer's compensation?
If your corporation loans you money it should be treated like any other arm's length type of loan, including the drafting of a promissory note with stated interest, repayment terms, the consequences of failing to repay the loan, collateral, etc. A below-market loan is a loan which provides for no interest or interest at a rate below the federal rate that applies.
If a corporation issues you, as a shareholder or an employee, a below-market loan, the lender's payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction. More information on "Employee's Pay/Kinds of Pay/Loans or Advances" can be found in Publication 535 Business Expenses on the IRS website.
This is my favorite topic. Here is usually an audit waiting to happen...
I can't tell you how many letters we see from the IRS reminding corporation owners that they ARE REQUIRED to take a reasonable salary before they start taking distributions from the company, and that corporation officers cannot pay themselves via 1099.
The IRS states "Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties."
You can refer to "Employee's Pay, Tests for Deducting Pay" in Publication 535, Business Expenses for more information on reasonable salaries, and public libraries or the internet may have reference sources that provide averages of compensation paid for various types of services.
The Internal Revenue Service may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder if the officer is substantially underpaid for services provided and/or has taken too much in distributions.
If you are a sole proprietor or partner in a partnership, the money or other forms of payment you take from your business should be accounted for in a draw account. This helps you know what amount of benefits you have taken from the business during the year. You cannot deduct the sole proprietor's own salary or any personal withdrawals made from the business.
Now, this is just a brief summary of the IRS rules on paying yourself out of your business. But there are often other details about your business structure that might throw you into another type of compensation situation, so I absolutely recommend you talk to your accountant, call us, or do some research on the IRS website to make sure you are paying yourself correctly.
Go forth and prosper!