The excitement that comes with starting your first business is most often tempered by the myriad of critical decisions you have to make. New businesses are sprouting up all over San Diego, and a common question for young entrepreneurs is “How do I pay myself?” The question is usually asked well after the new business is underway. It is common for new business owners to forge ahead with the expectation that as soon as they see a profit, they’ll simply pay themselves. However, as they think more about “how much” and “how” to pay themselves, they begin to wonder just how to accomplish the task. Do they withdraw profits for themselves? If so, can they do this any time or must they wait until year’s end? Do they pay themselves a salary including the withdrawal of state and federal deductions? What are the tax consequences? What about my partner?
The answer depends on your business’ structure. If you have formed a corporation, you would typically pay yourself as the corporation would pay any employee including the withdrawal of state and federal deductions. You would also have the option of paying out dividends. Determining what to pay and how to pay yourself requires careful consideration of the corporation’s anticipated profits. It makes little sense to pay yourself more than the corporation makes (whether via salary or dividends). The decision becomes more complicated if you have multiple shareholders but your Articles of Incorporation and By-Laws should be set up to clearly address management compensation and dividends.
As a sole proprietor, you pay yourself a draw from the company profits. When and the amount you draw from the business has no tax implications. You and the company are the same entity for tax purposes, and you pay yourself whatever you like. However, the ability to pay yourself and whether paying yourself makes good business sense are two different things. Withdrawing all of the company’s revenues leaving the company unable to pay expenses is never a good idea. It’s also important to know that what you pay yourself is not an expense for tax purposes. You don’t get to write it off. For a single member Limited Liability Company (LLC), you would pay yourself exactly the same way as you would for a sole proprietorship. LLC’s are considered pass through entities (as long as you did not elect to be taxed as a corporation) which means you are taxed the same as if you were a sole proprietor – you pay yourself a draw from the company profits.
You also pay yourself a draw from company profits in partnerships and multi-member LLCs (that do not elect to be taxed as corporations), although as with corporations, paying yourself becomes more complicated because there are multiple owners. In these circumstances, it is important to plan ahead and ensure that a well drafted partnership agreement or LLC operating agreement is executed. Otherwise, partners and LLC members will struggle with how to divide up profits and this can be devastating to young and growing businesses.
In the end, how much you pay yourself will be more important than how you pay yourself. You will want to balance your personal needs with the needs of your business. Whatever your financial goals, it remains important that you begin your new venture by carefully considering which business entity to choose, and this decision shouldn’t be made without first consulting your accountant or tax attorney.