One of the most common questions small business owners ask is, “Should I put myself on the payroll?” Unfortunately, like with most tax-related questions, the answer isn’t always straightforward. Whether you’re trying to maximize your Qualified Business Income (QBI) deduction or take advantage of employee fringe benefits, improperly paying yourself can lead to serious tax issues.
Let’s take a look at how the tax code allows you to pay yourself based on your business structure and the tax implications of each method.
Understanding the Tax System
The confusion around how to properly pay yourself stems from the two-track system for collecting taxes to fund Social Security and Medicare:
⦁ FICA (Federal Insurance Contributions Act): Covers employees and employers, requiring each to pay 6.2% for Social Security and 1.45% for Medicare (15.3% in total tax).
⦁ SECA (Self-Employment Contributions Act): Covers self-employed individuals, who pay the full 15.3% on self-employment income.
Since these taxes function differently based on whether you’re classified as an employee or self-employed, your business structure determines how you should pay yourself.
Sole Proprietors and Single-Member LLCs
If you operate as a sole proprietor or a single-member LLC (not taxed as a corporation), you’re considered self-employed. That means:
⦁ You cannot put yourself on payroll.
⦁ You report business earnings on Schedule C of Form 1040 and pay self-employment taxes.
⦁ You pay yourself through owner’s draws—taking money out of the business when needed.
Partnerships
If your business is structured as a partnership (including multi-member LLCs taxed as partnerships), you are not an employee. Instead, you receive income through:
⦁ Guaranteed payments: These are taxable and subject to both income tax and self-employment tax.
⦁ Profit distributions: Reported via Schedule K-1. General partners pay self-employment tax, while passive limited partners do not.
⦁ Partner draws: You can withdraw funds from your partner account as needed.
Important Note: Many new partners mistakenly believe they should receive a W-2 salary—this is incorrect under partnership tax rules.
S Corporations
If your business operates as an S corporation, your business earnings are not subject to self-employment tax. However, because S corporation officers are considered employees, you must:
⦁ Pay yourself a reasonable salary via W-2, which is subject to FICA taxes.
⦁ Take additional income as shareholder distributions, which are taxed but not subject to FICA.
⦁ Be careful—the IRS closely monitors whether S corporation owners underpay themselves in salary to avoid payroll taxes.
C Corporations
For C corporations, profits are taxed at the corporate level and again when distributed to you, resulting in double taxation:
⦁ You receive a reasonable salary via W-2, subject to FICA taxes.
⦁ You can receive shareholder dividends, but these are taxed both at the corporate level and personally.
Key Takeaways
The way you pay yourself depends entirely on your business structure and its tax implications:
⦁ Sole proprietors & single-member LLCs: Take money via owner’s draws and pay self-employment tax.
⦁ Partnerships: Receive income via guaranteed payments and profit distributions, with general partners subject to self-employment tax.
⦁ S corporations: Must pay a reasonable W-2 salary; any additional profits can be taken as distributions not subject to FICA.
⦁ C corporations: Pay yourself a salary (W-2) and possibly dividends, but be mindful of double taxation.
Understanding these distinctions will help you avoid costly mistakes and optimize your tax strategy.
If you’re unsure about the best approach for your situation, contact Saunders Tax & Accounting at www.SaundersTax.com or call us at 301-714-2071. Open Monday – Friday 9 am to 9 pm and Saturdays 9 am to 3 pm, except for March 22 open 9 am to Noon. Awarded the Hagerstown Chamber of Commerce “2023 Small Business of the Year” and Hagerstown Hotlist 2024, we have been providing a Less Taxing Life and More Prosperous Solutions since 1984!
