Do you know the best way to take income from your small business?
When many folks talk about a business owner’s income, they mention the word “salary”. Not every business owner takes a salary. Many factors influence how business owners take money from their business. The most important is the business structure.
Business structure affects how the owner takes the proceeds and the tax consequences related to the owner’s income. In the chart below, we display different business entities. For each entity, we list how owners take money from the entity.
|How to Take Income
|Schedule C with 1040
|Schedule C with 1040
|Schedule K-1 for 1040
|S corporation owner
|Schedule K-1 for 1040
|Dividend income on 1040
|not on dividends
|W-2 income on 1040
|FICA tax as an employee
Passive Income earned in a pass-through entity will not be subject to self-employment tax (SS & Med)
Draws, Distributions, Dividends, and Paychecks
The table above shows owners taking proceeds via a draw, distribution, dividend, or paycheck.
Under the draw method, you take (or draw) money from your business earnings as you see fit. Sole proprietors and owners of single-member LLCs take draws. These owners do not report this accounting transaction on their tax return. At the end of the year, sole proprietors report all their income and expenses on their tax returns on Schedule C.
With a distribution, the owners take a (predetermined) proportional share of the entity’s earnings. Business owners must report distributions (or a distributive share) on Schedule K-1 and report that on their individual tax returns.
When paying dividends, the corporation distributes its profits to corporate owners. Companies pay dividends to owners based on the percentage of stock held by each owner.
With the salary method of payment, you take a regular paycheck just like other employees.
With some entities (see chart above), owners take income from their company in a non-paycheck form (distribution or draw). Owners must pay Social Security and Medicare taxes on this income as the company and as an individual.
The IRS calls this double tax payment (the employer and the employee payments) a self-employment tax, which is 15.3% in 2019. This is paid by the employer based on a schedule determined by the IRS. Talk to your accountant to get the correct payment schedule.
Entity Types and Profit-taking
Below we provide detail on the method of taking profits for each entity type.
Two or more individuals can establish this unincorporated entity. The IRS does not subject partnerships to income taxes. At the end of the fiscal year, the partnership allocates a percentage of the profits (or loss) to each partner.
The partnership agreement details how the entity will allocate its profits and losses.
A partnership can use one of three methods to allocate its profits or losses:
1. Net Income Calculation and Closing Entries
2. Ratio-Based Allocation
3. Combination Method: Salaries, Capital and Ratio-Based Allocation
You can read more about the partnership allocation methods at this link.
The partnership files a Schedule K-1 for each partner. Individual partners must file and pay their own taxes on the share they receive.
LLCs (single-member and multiple-member)
Limited Liability Companies can have one member or multiple members. The LLC entity blends the ability to pass-through profits (like a partnership) and the liability protection of a corporation. The LLC’s profits pass to each member. Members pay personal taxes on the LLC income they receive.
State laws cover this type of entity. The IRS can treat the LLC’s distribution to partners as a corporation, partnership or as part of the LLC owner’s tax return. The agency automatically treats a single-member LLC as a sole proprietorship and a multi-member LLC as a partnership.
Under IRS rules, an LLC can request that the agency compute its taxes as a corporation. Please check with your accountant to understand how the LLC rules apply to your situation.
Technically, an S Corp is not a business entity. It is a closely held corporation (or occasionally an LLC or partnership) where the owners have selected their tax preference as Subchapter S of Chapter 1 of the IRS Code.
Similar to an LLC, the S Corp combines the ability to pass-through income (and losses) to shareholders with the liability protection of a regular C corporation.
The main difference between an LLC and an S Corp is how the owners pay their self-employment taxes. Owners of an S Corp receive a portion of income as a salary. The S Corp pays half of the employment taxes (Social Security & Medicare) and deducts the other half from the employee’s salary.
The IRS taxes the S Corp’s profits (income after deducting salaries and business expenses) at the individual’s personal income tax rate. The S Corp owner can also contribute to Health Savings Accounts and retirement accounts as part of the company’s business expenses.
Owners must be careful and take a “reasonable” salary to avoid IRS penalties. If the IRS determines that S Corp owners took unreasonably low salaries, the agency can reclassify some of the entity’s profit as salary and apply penalties. Talk to your accountant about what is a reasonable salary for your profession.
Another reason to avoid a very low salary is the IRS computes allowable retirement contributions based on the individual’s salary. If you are trying to max your retirement contributions, balance that with the self-employment tax savings.
With the 2018 tax law changes, some S Corporations can also benefit by having taxes applied to only 80% of their residual qualified business income (QBI). You can read more about QBI at our previous blog post.
You can read more about the tax and legal difference of LLCs and S Corp type companies at this link.
Corporate Owners (as an owner only and as an owner/employee)
C Corporations are not pass-through entities. With a C Corp, the IRS taxes the entities income at the corporate level. As with an S Corp, owners of a C Corp are shareholders. These entities can have owner/employees and non-employee owners.
C Corp owner/employees take their income in the form of salary and dividends. If the entity pays dividends, those payments are deducted post-taxes. Individual stockholders must then declare the dividends on their tax returns and pay taxes.
Some folks call this scenario double taxation. The IRS taxes the C Corp’s income at the corporate level and taxes it again on the individual’s tax return. To avoid double taxation, many experts recommend that C Corp owner/employees take as much in wages as possible.
Non-employee owners of a Corporation can only receive income from the corporation in the form of dividends.
If you have any questions about the taxes consequences of the different business structures, please contact us.