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Paying Yourself from Your Business

Owning your own business can be very rewarding. (It is also very time consuming!) But many people do not understand exactly how they get "paid" from their business. We summarize that important issue here, but it all depends on what form of business you have. There are four choices:

  1. Sole Proprietorship
  2. Partnership
  3. Corporation with S-Chapter election (S-Corp)
  4. Corporation without S-Chapter election (C-Corp)

What about the Limited Liability Company (LLC) you ask? Depending on the ownership and filing of an LLC it files taxes as one of the above.

Sole Proprietorship

This is the easiest type of businesses to form. It also has the simplest bookkeeping requirements. This type of business does not file a separate tax return; the profit or loss is simply filed as part of the owner's tax return. Therefore, there is nothing specific in paying the owner. The owner simply takes money out of the business as desired (and available!).

The important point is that the owner is NOT an employee. So there is no payroll for the owner, and no withholding, and no W-2. The owner must pay Self-Employment Tax in addition to income taxes. The 14.13% SE tax is in place of the 15.3% FICA otherwise paid.

Partnership

A Partnership is fairly easy to form, and maybe the easiest for multiple owners who are not married. But a Partnership has the most difficult bookkeeping requirements.

Like a Sole Proprietorship, the owners of a Partnership are not employees, do not receive paychecks with withholding, do not receive a W-2, and are subject to Self-Employment Tax instead of FICA. They can remove money from the Partnership as long as it is consistent with the partnership agreement, and they have the "basis" to allow for the withdraw.

When a Partnership desires to make disproportionate payments based on business activity, that is done through the Guaranteed Payment provisions of a Partnership.

When it comes time to file taxes, the Partnership files a special Partnership tax return that does not include any tax. But the return does include a K-1 (1065) for each partner, showing the partner's share of profit or losses. This transfers the partner's share of profit or loss into their own personal tax return, where the taxes are determined.

S-Corp

This is a corporation that elects to file taxes as a "pass-through" entity. This means that at the federal level it does not pay taxes, but transfers its profit or loss to the owners through a K-1 (1020S) similar to a Partnership. (California does assess a state income tax on the S-Corp.)

The owners of an S-Corp, presumming they are involved in the business, are employees. This means they must receive a paycheck, and that paycheck should include withholding of income taxes and FICA. (The S-Corp pays the employer's portionm of FICA just like other employers.) The owners will also receive a W-2.

Generally there is excess profit over and above the salaries or wages paid. This can be distributed to the owners in a consistent manner and is not a taxable event providing that the owner has the "basis" for the distribution. The taxes on this excess are determined on the individual owner tax return, having arrived through the K-1 (1120S).

C-Corp

This form of business is the most familiar type of employer, and owners are not treated any different than any other employee. They receive a paycheck with withholding for income taxes and FICA. They receive a W-2 just as other employees.

Any excess income is retained by the corporation where it pays its own income taxes. Income can be distributed to owners through stock dividends, where it will be taxed again. Thus a C-Corp type of business results in double-taxation for the owners.

"Tax software is no substitute for tax knowledge."

Any views expressed herein are based on our best information. The content of this web site was written as general information without specific individual information and thus may not apply in all situations. This material was not written, and cannot be used by the taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.

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Janelle Ogg, EA
Richard Ogg, EA