The Income Tax Impact – Different Ways to Pay Yourself
One of the reasons you started a business was to make some money. Once your business is proﬁtable, you have to decide whether, when, and how you want to transfer some of that money into your personal accounts. The different ways you can do that, and the potential tax implications, depend largely on your business entity. Sole proprietorships offer the least ﬂexibility here: your only option is withdrawals, and they have absolutely no impact on your tax situation.
That’s because you’ve already paid tax on all of the company proﬁts through your Schedule C. Taking money out of a sole proprietorship is strictly a balance sheet transaction. The same goes for beneﬁts: technically, it’s as if you bought your own health insurance or set up your own retirement plan, and any contributions made on your behalf count as withdrawals on the books.
What about payments to LLC owners?
Payments to LLC owners (also known as members) depend on how the company is taxed. When taxed like a sole proprietorship, payments are withdrawals; taxed like a partnership, they can be withdrawals or guaranteed payments. When the LLC is taxed like a C corporation, all payment options available to shareholder-employees are available to members.
Partnerships work in much the same way as sole proprietorships, at least when it comes to owners taking cash out of the company. In most cases, payments made to partners will count as withdrawals and have no tax impact. There is, however, something called a guaranteed payment to a partner; these payments get slightly different treatment than do standard distributions. Guaranteed payments are made to partners for roles other than simple ownership, such as employee or lender; as the name implies, these payments are guaranteed, unlike regular distributions. Also, regular distributions come out of capital and are usually based on a percentage of proﬁts; guaranteed payments are considered deductions for the partnership and cannot be measured as a percentage of proﬁts.
If you set up a corporation, you have more options available for paying yourself. The two most common are salaries (which are required of owner- employees) and dividends. Salaries are taxable to you as the employee and tax-deductible to the corporation as the employer. Dividends, though, offer no tax beneﬁt to the corporation, even though they’re taxable to the recipients.