Your tax classification determines whether you should be paid in distributions, a salary or guaranteed payments.
One of the things people look forward to the most about starting their business is paying themselves — but it’s also one of the most confusing.
As an LLC owner, there are certain rules you have to follow when paying yourself. The two main methods of paying yourself are salary and distributions. Your LLC tax designation is the biggest indicator of which one is best for you.
Most business owners only either use distributions or a salary to pay themselves. In reality, you should likely be using a combination of both. Learning how and when to use each method of payment can potentially save you in taxes and avoid costly IRS penalties.
So before you get your business up and running, learn what the rules are for each tax election and how they affect you.
Options for paying yourself
Business owners don’t have to wait on a paycheck every two weeks if they don’t want to. You can generally either go that route and put yourself on a salary or take out money from your business as you need.
Here are your options and what they mean:
- Distributions (all LLC owners): Transferring money to yourself directly from your business is most commonly called a distribution. It’s also referred to as an owner’s draw or a dividend. This method allows you to take out money from your business whenever you’d like and offers more flexibility with your cash flow.
- Salary (S corp owners only): S corporation owners are required to make a portion of their income through putting themselves on a salary like any other employee. Their salary has to be considered a reasonable compensation. Disregarded entity and partnership owners can’t pay themselves through a salary at all.
- Guaranteed payments (partnership owners only): This is a type of payment that’s specifically for partners in LLCs. Guaranteed payments work like salaries, except taxes aren't withheld.
How sole proprietors should pay themselves: distributions
If you registered an LLC without another owner and never elected to become an S corp, then your business is a disregarded entity (which is a sole proprietorship for tax purposes). That means your business income is reported on your personal tax return with a form called Schedule C.
You can pay yourself only via distributions if you’re a sole proprietorship. That means you’re responsible for paying your tax due throughout the year. You can do this by making quarterly estimated payments, where you pay the IRS every three months since your taxes aren’t being withheld. This could help you avoid a big tax bill at the end of the year. Talk to your tax advisor about how much you should pay in quarterly taxes — if any.
|💰 Learn more about quarterly estimated payments.|
Distributions give you more freedom and flexibility than a salary does, but only if you use them right. A mistake many business owners make is take distributions out whenever they feel like. Instead, you should create a deliberate schedule to take out distributions. This prevents you from paying yourself too much and not having enough to cover other business expenses.
Since your business entity is treated like a sole proprietorship, your profits and distributions are treated like the same kind of income — and all of it is subject to federal income tax and self-employment taxes.
How S corp owners should pay themselves: distributions and salary
S corporation payments have strict rules from the IRS. You have to put yourself on a salary, which must be considered reasonable compensation. You can also pay yourself through distributions on top of that.
How you split your income between your salary and your distributions is a matter of effective tax planning. In general, you should try to keep your salaried income as low as possible and make most of your income through distributions. S corp owners’ salaries are subject to payroll taxes, while their distributions are not.
However, your salary must be reasonable — meaning you can’t make it unrealistically low in order to pay less in payroll taxes. If the IRS doesn’t consider your salary to be reasonable, they can adjust it for you and charge you penalties and interest for not paying yourself properly. Any family members who also own or work at the company must be paid a reasonable salary, too.
If there are multiple owners in your S corp, distributions must be proportionately distributed according to how your business is split up. So if you split your S corp with another owner 50/50, distributions also need to be split down the middle. This should be laid out in documents agreed on and signed by you and the other owners.
How partnership owners should pay themselves: distributions and guaranteed payments
Partnership owners can pay themselves via distributions and guaranteed payments.
Guaranteed payments are just like salaries — except they don’t have payroll taxes withheld. The amount you and your partner(s) get paid is usually outlined in your LLC’s operating agreement, which should be solidified with the help of an attorney before you start your business.
Unlike S corps, distributions for partnerships don’t have to be proportionate to each owner’s share. Each partner can take out how much or how little they want, as long as you’re following the rules of your operating agreement.
You have to pay a 15.3 percent self-employment tax on your share of profit and your guaranteed payment amount if you’re an active owner of your business — meaning you actually participate in what your business does.
Since distributions and guaranteed payments don’t have taxes withheld, you’re responsible for paying taxes throughout the year via quarterly estimated payments. Talk to your tax advisor about how much you should be setting aside to pay the IRS and avoid penalties.
The bottom line
Determining how you should pay yourself can be one of the most confusing parts of starting your business.
There are two ways most business owners get paid: distributions and a salary. And for partnerships, guaranteed payments should also be in the mix. Learning how and when to use each method can either save you in taxes or cause the IRS to audit you.
If you need help figuring out the best method for paying yourself, schedule a free call with a DiMercurio Advisors team member today — because you don’t have to make sense of your business’ taxes alone.