So that “crazy little business idea” you had is starting to gain attention and you’re actually making revenue. That’s great! Now that your side project has become a full-time job, you need to determine how you’re going to pay yourself. There are several options available so choosing the best one for you and your business is critical.
First, you must decide what type of entity you want to incorporate your business as, because that will determine how it will be taxed. You can become a Corporation (C-Corp), an S-Corp, a Limited Liability Corporation (LLC), a Sole Proprietorship, or a Partnership. (More to come about the differences in a future blog post). A part of this process is deciding whether you are comfortable being taxed at the individual level, or whether you would prefer to simply pay business taxes. It’s an overwhelming and important decision! But ultimately, you need to decide what type of entity you want to be before you can worry about paying yourself.
We’ve outlined some of the major differences around owner pay below and are here to help you make the best-informed decision for your business. Please note: while we do know a lot about what we’re talking about (i.e., finance, accounting, and taxes), we absolutely recommend consulting a lawyer to file your articles of incorporation.
Now that you’ve decided how you want to incorporate your business, you must decide how you want to pay yourself.
The owner’s draw is an option if you are a partner in the business. Most agencies go with this option unless you’re taxed as a corporation in which case the IRS requires you to pay yourself a reasonable paycheck. When you choose to do an owner’s draw, you keep track of this spend through your balance sheet, as opposed to a P&L (income statement), so you aren’t reducing your company’s profits by paying yourself. Your draws are reported annually on the K1 you receive from your tax accountant – this also means you are taxed at the individual level.
When your business does make a higher profit, unfortunately, you end up paying more taxes, but that’s the nature of the beast.
This is the most common type of payment structure, as many business owners are considered W-2 employees. If you take this option, you still must pay yourself a “reasonable” salary as defined by the IRS. This means that your income makes sense for the duties you are completing every day and the amount of responsibility you are taking on compared to the overall gross and net income of the company. For this option, your company pays the employer portion of the payroll taxes (Medicare, Social Security, Unemployment, etc.) as opposed to a sole proprietor who would pay both the employee and employer portion of payroll taxes. Unlike the owner’s draw, this is tracked on the P&L, so it will directly reduce your company’s tax liability if you are profitable, or increase your net operating loss (NOL) if you are not profitable.
This payment structure is only applicable if your business is a partnership. As the name suggests, your pay does not depend on the success of the business. This practice ensures that each partner is compensated for their individual contributions to the business. This eliminates the risk of a partner losing their investment since they are guaranteed to be paid whether or not the business makes enough money. This is also tracked on the P&L, so it will reduce your net income. Unlike the typical employee salary or payroll, the company does not pay the employer portion of taxes. Guaranteed payments are reported by the employee who receives them as self-employed income, for which they pay both the employee and employer portion of taxes.
There really is no definitive answer when it comes to how you’ll be paid as a business owner as long as it’s within the legal boundaries and you make a decision that’s best for the future and stability of your business.