Toby Mathis, Esq. and Jeff Webb, CPA, break down how to pay yourself using different business entities.
Updated September 3, 2020
After setting up business entities to run your investments through, you may have questions about how to actually pay yourself from your entity. I’m going to give the typical lawyer answer here: It depends. Ultimately, the way you take money out of the business depends on the entity type.
There are two main kinds of businesses in question: entities that are not separate legal taxpayers (pass-through entities), and those that are (corporations). In general, there are four different business entity types that could fall under these two categories: sole proprietorships, partnerships, S corporations, and C corporations.
Before we get started, I know some of you are already wondering What about my LLC? Your LLC could be taxed as any of these (sole proprietorship, partnership, S corporation, or C corporation). Keep in mind that LLCs don’t exist in the eyes of the IRS. Thus, we tell the IRS how to tax an LLC.
With sole proprietorships, you and your business are the same. Due to this, sole proprietors are 700% more likely to be audited by the IRS than their S corporation or partnership counterparts. Furthermore, in the event of a sole proprietorship audit, the IRS wins 94% of the time. As a sole proprietor, you’re not likely to fare well in an IRS audit. This unfortunate reality stems from the fact that you and the business are the same. Because of this, the audit will likely find that all or most expenses are personal, not business, expenses.
Getting money out of a sole proprietorship is simple. You can’t pay yourself a salary because you and your business are the same. Since it’s the same bucket for both you and your business, you could even use the same account.
The same is true with partnerships. With both partnerships and S corporations, which we’ll discuss shortly, you’re taxed on your share of the income — whether or not you pay yourself out. There are some exceptions to this, including limited partnerships or managers of LLCs taxed as partnerships. However, for the most part, whether you leave the money in a partnership or take it out is immaterial. It doesn’t matter. The tax ramifications are the same.
As previously mentioned, S corporations are pass-through businesses. Like partnerships, if you have an S corporation, you pay taxes on your share of the income regardless of whether you pay yourself a salary.
Unlike other pass-through entities, S corporations offer a huge benefit that partnerships and sole proprietorships do not: the distinction between wages and distributions. With S corporations, these are two separate buckets. The distribution bucket is one you can take money out of all the time since the taxes pass through to you as the owner.
Also known as traditional corporations, C corporations are separate taxpayers entirely. Thus, C corporations are not pass-through businesses. C corporations pay a flat 21% tax on profits. If a C corporation pays you out anything, it’s either in the form of a dividend or compensation. If it’s compensation (you’re being paid for your time and/or efforts), it’s W-2 income. If the C corporation pays you out profits, it’s a dividend. If you’re reimbursing yourself, you simply write yourself a check after submitting a request to the company for expense reimbursement.
With every other entity discussed above, it’s pretty easy to take money out whenever you want. With C corporations, since they’re a separate taxpaying entity, there may be different tax considerations.
For instance, let’s look at an example income of $100,000. If you as an individual taxpayer are at the highest income tax bracket, you’ll pay 37% in taxes on that $100,000 of income. If a C corporation makes the same $100,000, it pays a flat 21% tax. After taxes, if the C corporation distributes that money to you, you must recognize that as a dividend, which is taxed at the long-term capital gains rate. Again, assuming you’re in the highest tax bracket, you’ll pay 20% on dividends. Furthermore, you’ll pay an additional 3.8% tax on net investment income.
At the end of the day, when you start to add these things up, your taxes are likely to hover around 37% no matter what. A lot of people make the false assumption that a C corporation is the panacea to solve all tax ills. However, if you need the money, you’ll most likely have a similar tax consequence no matter how you get the money out.
Where C corporations really make a tax difference is when you don’t need the money. If you can park the money in the C corporation and let the corporation use it, that’s when you’ll see major tax benefits. This is called income splitting.
Which Entity Is Right for Me?
As you can see, there are many different considerations when it comes time to select your business entity type and overall structure. If you’re not sure what the best structure would be for your individual situation and financial goals, claim your complimentary structure consultation now. On the call, one of our experienced and knowledgeable Advisors will provide guidance on the best entity type to use for your unique business or investing. You can schedule online or by calling 800.706.4741.