Congratulations! If you are reading this, you are thinking about or have already made the leap into forming your own business. It can be a scary time, with many things to consider and major decisions to be made.
One of the biggest things to consider is how you are going to pay yourself. After all, the major reason that we work is to pay for life.
Rule 1: How You Pay Yourself Matters
Paying yourself in a sole proprietorship looks very different compared to paying yourself as the owner of a corporation or LLC. There are multiple factors to consider, and each one has different tax and legal ramifications. With most structures, you need to be able to show the IRS or state tax entities how much you are earning and how you are earning it. That means that you not only need to pay yourself in a specific way, but you may also need to use documentation to prove payments.
If you are using a corporate or LLC structure, keeping the business assets separate from your personal funds is extremely important to maintain the limited liability of the business entity. Transferring funds back and forth between yourself and the business bank account frequently can undermine these protections.
Rule 2: Reasonable Compensation Should Be Determined Through Research and Careful Thought
The IRS requires that businesses, like an LLCs and other corporations, pay corporate officers and owners "reasonable compensation." However, it can be tough to determine what reasonable compensation may be for your role in your own business. If you pay yourself too much, you are taking money out of the company that could have been used for growth, expansion or even everyday purchases. On the other hand, if you pay yourself too little, you may not be able to get by on a daily basis.
Another factor to consider is that if you are underpaying yourself, the IRS may adjust your reportable income to reflect how much you should be paid based on your title and role in the business. They do this to avoid situations where business owners do not take enough compensation to avoid paying income taxes. Failing to pay required taxes can result in significant penalties and interest.
Here are some of the ways you can determine what reasonable compensation is:
Comparable salaries of other individuals in your industry
Duties you are performing as part of your position
How much time and effort you are investing into your business
Your level of responsibility within the company
Whether your pay is directly related to the hours worked and your pay compared to other employees' wages at your business.
Rule 3: Sole Proprietors and Partnerships Do Not Have Salaries
With the majority of gig and freelance workers working on their own, many are choosing to structure their business and payments as a sole proprietor or partnership. With these types of structures, you do not pay yourself a salary, which means there are no payroll taxes deducted from your payments to yourself. Business owners who operate a sole proprietorship have the most leeway when it comes to paying themselves. As a sole proprietor, you can literally take draws whenever you want, for any amount that you want, with no oversight.
Payments to Social Security, Medicare, and state and federal income tax authorities are obviously not paid in the payments you make to yourself in a sole proprietorship or partnership. Instead, you must track all of the payments you make to yourself and pay self-employment taxes on them at the end of the year. For 2017, the self-employment tax rate is 15.3 percent.
Most self-employed individuals who operate under a partnership or sole proprietorship will make quarterly tax payments (often referred to as "estimated tax payments") to the IRS and state taxing authorities. This requires setting aside a portion of your income to make these payments.
What structure works best for you? Tell us in the comments!
About the Author
Corey Bray is the CEO and Founder of LegalNature. A serial entrepreneur, Corey has successfully exited several startups and is currently focused on revolutionizing the business document industry.