When you first incorporate your business, how you pay yourself may seem insignificant. It can be a straightforward process for some business types, such as a sole proprietorship or a limited liability company. However, it can be more complex when dealing with an S corporation.
There are three ways to pay yourself when you own an S corporation: by distribution, also known as the owner’s draw, salary, or a combination of both. Choosing the right option can have a lot to do with how you contribute to your business and its financial performance.
In this article, we will take a closer look at the available options and how payment structures differ for an S Corp compared to other business models. We hope this information will help you determine which payment option is right for you.
The Three Ways to Pay Yourself: Salary, Owner’s Draw, or Both
An S corporation owner that handles their business operations must take on the role of a company employee and a shareholder. However, owners who do not oversee their daily operations are considered shareholders only. Under the S corporation structure, the role you take on will have a direct effect on how you are paid.
Option 1: Employee’s Salary
If you take on any employee responsibilities for your business, you must draw a W-2 salary. Doing so allows you to report and pay your employee taxes.
There are several advantages associated with this option. First, you know exactly how much you will receive every payday instead of simply taking a lump sum from your bank account whenever you need money. That can make it much easier for you or your accountant to manage your cash flow.
The downside to receiving a salary is that you must ensure you are paying yourself an adequate amount to avoid any speculation from the IRS. According to the IRS, all S corporation employees must receive fair compensation equal to a salary paid by other businesses in your industry. Still, they cannot be paid so low that they avoid paying certain taxes.
If the IRS finds out that your compensation doesn’t meet the reasonable amount, they can penalize you for failing to withhold or deposit employment taxes. In addition, they may impose a penalty for any back taxes you and your company owe.
If you take an employee’s salary, keep track of all data and documents used to calculate your compensation amount in case the IRS audits you.
Option 2: Owner’s Draw
Suppose you are not very active in the operation of your company and do not provide many services to your S Corp. In that case, you can take the owner’s draw and draw money from your business using shareholder distributions.
A distribution is a payment of earnings to all business shareholders. It is usually in cash or stocks and is taxed on a shareholder level. That differs from a salary because these payments are not subject to employment, Social Security, Medicare, or payroll taxes. Instead, each year, the owner’s draw payment is taxed on the shareholder’s tax return.
The upside of taking the owner’s draw is that it provides more flexibility with your wages; you have the option to make adjustments to your compensation based on how well your company is performing and your personal financial needs.
However, it would be best if you kept in mind that while you do not have to pay taxes on a shareholder distribution until you go over your stock basis, once you do go past that amount, you will be obligated to pay. And unlike a C corporation with a stock basis that remains the same yearly, an S Corp’s stock basis will fluctuate as the business experiences profits and losses.
Option 3: A Combination of Both
Suppose you are the owner of a business and also a shareholder-employee. In that case, you can pay yourself using a combination of a salary and an owner’s draw as long as the payment you receive is adequate for the work you provide. Additional profits may be taken as distributions with lower tax.
Your distributions will not be subject to employment taxes as long as your salary meets all the rules. However, the same rules apply as we mentioned earlier about taking a lower salary. In addition, the IRS may decide to reclassify other compensation you receive as taxable income.
If you are unsure about how this option may affect your finances and tax payments, consult with a CPA in your area to determine a reasonable salary for a business like yours in your state. Doing so will help you avoid issues with the IRS.
There are some companies that will require you to take an owner’s draw instead of an employee’s salary. In that case, you can only take a salary if you are an active employee and are essential to the daily operations of the business.
In What Ways are Payment Structures for an S Corp Different From Other Business Models?
An S corporation has a unique payment structure that allows companies to shield themselves from liability, allowing them to get the most out of their tax benefits. That means, unlike a sole proprietorship or partnership, the owner of an S Corp and their shareholders are not responsible for any business debts. The benefits of this structure include having your assets protected if your company is ever sued or cannot pay off creditors.
There are several tax benefits associated with filing an S corporation. With a C corporation, you can include all the positive attributes without double taxation but with an S Corp, all corporate profits and losses go through the shareholders, like in an LLC or partnership. This results in the business income not being subject to any corporate tax. Instead, the shareholder is responsible for paying taxes on the business profits whenever they file their individual income tax.
Additionally, owners of LLCs and sole proprietorships will pay a self-employment tax on their total business profits. S corps, however, will only pay self-employment tax on their wages. All other income is distributed to the shareholders, and because these distributions are not subject to self-employment tax, the S corporation structure is popular among small business owners.
Owner’s Draws and Owner’s Equity
If you plan to sell your company, you must keep track of your owner’s equity. It shows you how much money you are entitled to once you have paid off all company debts and sold your S Corp to a new owner. The formula to calculate it is:
Assets - outstanding liabilities = owner’s equity.
Assets include any money you have personally invested in the business and any profits from it. Outstanding liabilities are any business debts left over or any money that has been deducted from the company, which can include the owner’s draw.
How to Determine a Reasonable Salary for Yourself
To determine what a reasonable amount would be for your salary, you can look at analysis reports or do research on by looking at data from resources such as the Bureau of Labor Statistics.
Once you have decided on a suitable figure, you may need to adjust it based on your individual or company’s circumstances. For example, a business owner may take a lower salary if they do not work for their S Corp 40 hours a week or if their assets contribute more toward the business earnings than their labor contributes. It’s also important to mention that while the IRS may question a lower salary, they do not require S Corp owners to reimburse themselves if the business is not generating income.
Use the 60/40 Formula
One way to ensure that you have determined a reasonable salary for yourself as a business owner is to follow the rule of 60/40. When using this formula, you divide your company’s income, with 60% allocated as salary and 40% given as distributions to shareholders. (Note that while many bookkeepers use the 60/40 method, it is not usually accepted by the IRS.)
We’ve discussed three options for paying yourself as the owner of an S corp. The first is to take a salary, and this is required if you are providing services as an employee would. Remember though, the IRS requires you to pay an amount that’s high enough to not avoid paying certain taxes.
If you’re not that involved with day-to-day operations, you can take an owner’s draw (which needs to be deducted when calculating owner’s equity). Finally, in some situations, you may be able to take both forms of payment (and as with the first option, your salary needs to be at a suitable level to avoid difficulties with the IRS).
Now that you know the difference between a salary and an owner’s draw and how each relate to your company, you have the information needed to decide which payment option is the best choice for you. Overall, you want to make the best decision for your business that will keep the cash flow moving forward and your profits soaring without any suspicion from the IRS.
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