What is the proper way to take money out of my business?

Key Takeaways

• The way you pay yourself from your business profits will depend on how your business is structured. 
• If you have an LLC or sole proprietorship, you will be paying yourself in the form of owner draws. You will not receive a salary. 
• If you are the owner and employee of an S Corp, you will likely pay yourself through a combination of both shareholder distributions and salary. But, you must take a salary.
• Owner draws and shareholder distributions are generally not taxable. However, you will pay tax on your business profit at the individual level. 
• You should keep track of the money you take out of your business even if you do not need to report that information on your tax return.

Single-Member LLCs and Sole Proprietorships

When your business is structured as a single-member LLC or sole proprietorship, the payments you make to yourself from profits are known as owner draws. This method is very flexible because you can transfer funds to your personal bank account whenever you want or need. Since the payments are not fixed, you can adjust the amounts based on your business’s profitability (or not take owner draws at all). Owners of these types of businesses are not allowed to pay themselves a salary, so no W2 will be issued at year-end. 

Owner draws are not subject to tax. Instead, you pay tax on your business profit when your individual income tax return is filed. This profit is subject to regular income tax as well as self-employment taxes which are currently 15.3%.  

Although you do not need to report owner draws on your tax return, it is still beneficial to track the draws taken during the year. Additionally, you should maintain an up to date Profit and Loss report showing your business income and expenses. This will be needed for your tax return, and it will also help you determine how much money you can take from your business to pay yourself. 

Multi-Member LLCs and Partnerships

If you have a multi-member LLC or partnership you will most likely still use the owner draws method. You will not pay yourself a traditional salary. However, revenue will need to be split among partners or members. This split should be outlined in your partnership or operating agreement to prevent issues down the road. 

Each year, you will receive a K-1 from the partnership showing your share of owner draws, business profits or losses, credits, etc. Any partnership profit or loss will flow through to your individual return, and you will be taxed at that level. 

S Corporation Owners

There are two primary ways to make payments to yourself as an S Corp owner: shareholder distributions and salary. Oftentimes you will pay yourself using a combination of both these methods. This is particularly true when you are the only owner of your S Corp. The difference between the two lies in the way you make and receive the payments as well as how the payments are treated for tax purposes. 

Method 1: Shareholder Distributions

Shareholder distributions are easy to make because all you need to do is transfer funds directly from your business bank account to your personal bank account. They are tracked throughout the year in the equity section of the balance sheet. 

These payments are not subject to payroll taxes, employment taxes, or Social Security and Medicare taxes. Instead, your portion of the business’s profit will be taxed at the shareholder level on your individual income tax return. It is important to keep an eye on your stock basis though because any distributions made in excess of this basis are taxable. 

Method 2: Salary

Since there are no payroll taxes on distributions, it seems crazy at first to pay yourself any other way. The catch is that the IRS says S Corp owners who also act as employees of the company must pay themselves a “reasonable salary” before taking any tax-free distributions. Payroll taxes are paid on this salary, and a W2 will be issued each year. The benefit is that you receive a set amount of money which helps with managing cash flow. A W2 can also help with personal finances such as getting a mortgage to buy a house. 

Although there are no specific guidelines for determining a reasonable salary, the IRS does consider several factors. These include training, experience, responsibilities, time devoted to the business, dividend history, and others. It is also helpful to find out what comparable businesses are paying for similar services.

In addition to the factors the IRS looks at, you may also want to account for:

• Your company’s profitability. 
• Your personal income requirements. 
• Your location and cost of living. 
• Your lifestyle. 

You should keep records documenting how you came up with your reasonable compensation amount should the IRS have questions. If the IRS determines a salary is not reasonable, they can reclassify some of your distributions as wages and impose tax penalties. 

Estimated Tax Payments

When you have a profitable LLC or a sole proprietorship, you may be required to make quarterly estimated tax payments. This is because, unlike with a regular W2 job, no taxes are being withheld from your business profits throughout the year. The IRS expects people to pay tax as their income is earned, and quarterly estimates are a way for self-employed individuals to do this. 

S Corp owners do have taxes withheld from their salary during the year. However, it may not be enough to cover the entire tax liability at year-end depending on business profit and tax withholding. For this reason, quarterly estimated tax payments may still need to be made in addition to the payroll withholdings. 

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If you need assistance with bookkeeping for your small business, and your books are on the cash-basis within QuickBooks Online, reach out to us! We'd love to help. We specialize in service businesses and non-profits.