Do you own a small business and need to know how to compensate yourself? The way you pay yourself depends on the type of business entity you own from a legal standpoint.
There are five possible scenarios:
1. Sole proprietorship. The sole owner of an unincorporated business does not pay himself as an employee of the business, and so the sole proprietor should never receive a Form W-2 from his business. Nor does he pay himself as an independent contractor and thereby receive a Form 1099-MISC from his business.
Instead, a sole proprietor distributes profits to himself in the form of the so-called “owner’s draw.” He simply writes himself a check or transfers money from the business account to a personal account. Regardless of how much profit he distributes to himself, the net profit of the business is reported on Schedule C of his personal income tax return, where it is subject to both income tax and self-employment tax.
2. Partnership. The partners in a partnership are also not compensated as employees or independent contractors. Partners can receive guaranteed payments for their services to the business. They can also receive profit distributions from the business. Both guaranteed payments and profit distributions are reported on Schedule K-1, which is given to the partner at the end of the year. This K-1 information is transferred to the partners’ personal income tax returns, where both income tax and self-employment tax are incurred on that K-1 income.
3. C Corporation. If the owner of a C Corporation performs services for the corporation, he should be paid reasonable compensation as employee of the corporation and receive a Form W-2 at the end of the year. The corporation can also pay dividends to the owner, which are reported on Form 1099-DIV. Both the W-2 income and the 1099-DIV income are then reported on the owner’s personal income tax return.
4. S Corporation. Similar to the C Corporation, if the S Corporation owner performs services, he should receive reasonable employee compensation that is reported on Form W-2. Any corporate profits are reported on Schedule K-1 and then transferred to the owner’s personal income tax return and subject to income tax. The K-1 income does legally avoid both payroll taxes (Social Security and Medicare taxes) as well as self-employment taxes. Sometimes this K-1 income is referred to as a dividend, but not in the same sense as a C Corporation dividend, as no Form 1099-DIV is issued to an S Corporation shareholder for distribution of profit.
5. Limited Liability Company. LLC’s can be taxed as a sole proprietorship, a partnership, a C Corporation, or an S Corporation. So the owner is paid in accordance with the overall tax treatment of the entity, as indicated in each of the above four scenarios.