The first thing I want to share with you is that your business structure determines how you get paid as a small business owner as follows:
- A Sole Proprietor “draws” money from their business profits
- Members of a Partnership are paid with a “guaranteed payment” or “distribution”
- Shareholders of an S or C Corporation are paid “salaries” and “dividends”
All owner payments come from the profits of the business. Owner draws and distributions from business profits are “Equity” transactions that show up on the Balance Sheet and do not show up on the Profit and Loss Statement. Owner Salaries and Guaranteed Payments are payroll expenses that show up on the Profit and Loss Statement.
Profitable Sole Proprietors, LLC’s and Partnerships are required to calculate and make quarterly estimated tax payments, including self-employment tax. Note that S Corporation owners only pay self-employment tax on “earned” income, they do not pay tax on profit distributions, and C Corporations are not required to pay self-employment tax at all.
Sole Proprietors Need to Pay Federal, State & Self-Employment Tax
The IRS considers a sole proprietor an unincorporated business that is owned by a person that owns and operates the business themselves, they are self-employed. As a sole proprietor you do not pay yourself a salary and you cannot deduct a salary as a business expense on your P&L Report. Your personal income from the business comes from the profits of the business, which are reported on your personal income tax return. As a sole proprietor you will need to pay federal and state income taxes on the profits of your business in addition to self-employment taxes (Social Security and Medicare).
Your self-employment taxes are calculated on the profit of your business. The owner draws are recorded as negative entries against Equity. You are to set aside money for state, federal and self-employment taxes, as you will be required to make quarterly estimated tax payments once your business become profitable, after year-one. Sole Proprietors, LLC’s and Partnerships are subject to self-employment taxes at 15.3%.
The Social Security portion of self-employment taxes (FICA) for 2018 is 12.4% (6.2% + 6.2%) of the first $128,400 of your net income plus Medicare tax at 2.9% (1.4% + 1.4%). On average, small business owners need to set aside 25% – 30% of their income for estimated income and self-employment taxes.
Information on Self-Employment Tax can be found on the IRS website here:
Limited Liability Companies are Considered Disregarded Entities
A Limited Liability Company (LLC) formation is a State level designation and it is not considered to be separate from the person who owns the business. The only reason for the designation is to protect business owner’s personal assets from a potential lawsuit. What this means from the IRS perspective is that the business is not separate from the owner, and that all of the retained profit of the business is considered to be income to the owner.
The IRS does not allow the owner to deduct the draws (shareholder distributions) they take from the business as an expense. These draws are negative Balance Sheet entries to Equity. Limited Liability Companies must make sure to set aside a percentage of their income to save for taxes. As an LLC you can pay yourself as an employee or a member who receives distributions of the business profit.
In order to pay yourself as an employee you must be actively working in the business. Because employee wages are considered operating costs they can be deducted as business expenses for the LLC that will show up on the Profit and Loss report and reduce profits. If you pay yourself an employee salary a W-4 form will need to be filed with the IRS to determine the amount of payroll withholding from each paycheck you receive. The LLC will pay you as a W-2 employee and will withhold income and employment taxes from your pay.
You will pay income taxes on your earnings. If you choose to receive distributions of profits from the LLC you can do this annually, or you can setup a recurring draw against the year-end profit. The total of all the draws throughout the year are deducted from the total profits at year-end.
If you are the only member of the LLC, you will be required to pay income tax on your distributions and file a schedule C to report your profits and losses with your personal tax return. If there is more than one member of the LLC, the IRS will treat the LLC as a Partnership and each partner will report their share of the profit and pay income tax on it.
The LLC then files form 1065 to report the division of profits between the LLC members. You are entitled to year-end profit distributions regardless of whether you are paid a salary as an employee of the LLC.
If you do not pay yourself a salary and you do not make draws from the profits of the business, you will still be required to pay income tax on the profits earned on your personal tax return. Information on Limited Liability Company Tax can be found on the IRS website here:
Partnerships are Taxed on the Full Profits of Their Business & Split
There are partnership agreements that define how the profits are split between the partners of a business. The full profits of a Partnership business are taxable. Each partner in the business is responsible to pay their percentage of the taxes on the business profits. Therefore, if one partner has a higher percentage of the business than another, they get a higher percentage of the profit and pay a higher percentage of the taxes.
Partners are paid with distributions, but they can choose to increase their partner equity in the business by retaining this money in the business. These distributions, whether retained in the business or received by the partner are Balance Sheet transactions that never show up on the Profit and Loss Statement.
However, if a partnership agreement states that there is a “guaranteed payment”, these payments are made to partners in a business for work they do for the business and they are not based on the percentage split of the business. Unlike distributions, these payments do show up on the Profit and Loss Statement as a business expense and ultimately reduce the profits of the business.
The distributions of profit to Partners are then calculated on the Net Profits (after the deduction of the guaranteed payments). Partners have to pay self-employment taxes on their distributions with quarterly estimated taxes.
LLC’s and Partnerships Can Choose to Be Taxed as S Corporations
When a Limited Liability Company or a Partnership elects to be taxed as an S Corporation their tax liability is passed on to its owners (members or partners) based on their percentage of ownership of the business, and the business Entity has “No Tax Liability”. The business shareholders of an S Corporation receive salaries that show up as payroll expenses on a Profit and Loss Statement. The shareholder distributions of profit only appear on the Balance Sheet.
S Corp shareholders are most often employees of their business. These shareholders get added to the company payroll and are subject to the same withholding taxes as other employees. The business paid portion of the payroll taxes and the salary expense reduces the profit of the business. The remaining profit of the business is distributed to shareholders by percentage.
Individual shareholders can choose to retain their percentage of the profit in the business itself to increase their “equity” in the business. These profits are taxed at a lower tax rate than the self-employment tax.
S Corps Pay Taxes That Average 40% of Net Income Up to $500K
If you elected to be treated as an S Corporation as an LLC owner, you will be required to file IRS form 1120S. The average savings in self-employment taxes for S Corps is between 8% -10% of the net profit of the business after expenses.
That is after the business pay for the additional expenses related to becoming an S Corp. When your business is taxed as an S Corp you become both an employee and a shareholder. As an employee your income is subject to Federal, State, Social Security, Medicare, Unemployment and Disability taxes. As a shareholder you are getting a return on your investment like a dividend paid to a C Corporation shareholder, it’s just called a distribution instead of a dividend.
S Corp Shareholders Must Receive Reasonable Compensation
Putting profits back into the business reduces the taxes you pay because you are not keeping the money as personal income, you are putting money back-in to the business, investing in your business. The IRS says that S Corp shareholders must receive “reasonable compensation” that equates to what an employee would earn for the work that they do for the business.
An IRS auditor can determine that distributions should have been wages and therefore additional taxes, penalties and interest are due. As an S Corp you must have regular shareholder meetings and record your meeting minutes. S Corps are subject to stricter controls than LLC’s, Sole Proprietorships’ and Partnerships. S Corp shareholders need to be “very” careful about co-mingling personal and business expenses. The IRS frequently audits S Corporations, and closely reviews expense deductions and taxes paid.
C Corps are “Double-Taxed” as Their Salaries & Profits are Taxed
There are not many small businesses that form as C Corporations. These types of businesses are essentially “double-taxed”. The shareholders of C Corps pay themselves a salary and profit distributions. And the tax liability of the Corporation belongs to the business.
The shareholder salaries and distributions are taxable, and the profits of the business are taxable. As a C Corp you do not have to pay self-employment taxes on “all of your net earnings” the way a Sole Proprietors or a Limited Liability Companies does. Shareholder employees of S and C Corps pay employment taxes (Social Security and Medicate) only on the employee salaries they receive.