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Boss, it's time to pay yourself! Here's how

An owner of a new company can rarely take money out of the business. Any money made from sales generally has to be poured back into the company in order for it to grow and prosper.

That's conventional small-business wisdom.

Conventional wisdom, however, never gets hungry or has a mortgage payment due. But because you live in the real world, eventually you're going to have to pay some bills. What are the legalities and the practicalities of drawing money from your business?

In terms of tax consequences, it depends on how your company is structured, says Michael Koppel of the accounting firm Gray, Gray & Gray LLP, in Westwood, Mass. In "pass-through" companies -- such as sole proprietorships, limited liability companies and S corporations -- income to the business entity is not taxed. Instead, it is passed through to the individual owner or owners and taxed there.

In the case of S and C corporations, the owner as an officer of the corporation can be paid in salary and in distribution. (Distributions are profits passed onto you as a shareholder.) The salary is subject to employment taxes, but distributions are not.

Below are the strategies recommended for drawing income based on your company's legal structure. Remember -- these are general guidelines. For advice specific to your situation, it's best to check with your accountant or financial adviser:

C Corporations
Although few small businesses are C corporations, some do exist. For those companies taxed on their income, it's beneficial to pay as much compensation as possible as salary, says Jeff Pannell, a partner and CPA with Clark Nuber, an accounting firm in Bellevue, Wash. That reduces the company's tax burden -- it can deduct paying you as CEO, but giving you a dividend is not tax deductible. The downside for you personally: You'll be paying employment taxes on your salary.

There are no tax codes related to reasonable or unreasonable compensation. So it's up to the individual Internal Revenue Service agent to decide if what you're claiming on your corporate or individual tax return makes sense.

It all comes down to what's reasonable. If you're paid $200,000 in salary and your company's only posting $210,000 in profit, that may raise a few eyebrows -- and the specter of an audit -- with the IRS.

In addition to those types of red flags, the IRS will also seek comparisons -- how much do CEOs make in comparable companies? The agency will look at salary surveys in your industry to try and make an assessment of what's reasonable and what's off the wall.

Of course, as a small corporation, your aim should be to avoid an IRS hearing. Pay yourself a salary that's commensurate with industry standards and is in line with what your company is making, Pannell says.

Another way to essentially get paid is through fringe benefits such as health insurance premiums and direct reimbursement of medical expenses. Your company can deduct the cost of these benefits and they're not treated as taxable income on your tax return.

S Corporations
"Here, the situations are nearly reversed," Pannell says. "S Corporations tend to want to undercompensate and have employees take more in the way of distribution."

That's because compensation is subject to employment tax. Distributions are not.

Again, being what the IRS deems "reasonable" is crucial.

"If you're a lawyer and you take all your compensation as distributions and don't take a salary, the IRS will decide that you've disguised a salary as a distribution. They will recast it," says Mike Petrecca, tax and legal services partner with PricewaterhouseCoopers in Columbus, Ohio. "On the other hand, if you're pulling down a $100,000 salary and receive a distribution of $50,000, the IRS probably won't say a word." That's because it's clear that you are receiving a reasonable salary in addition to, rather than as a substitute for, a distribution.

While nobody wants to raise the ire of the IRS, the good news is that while you'll have to pay back taxes if the IRS decides to reclassify distribution money as salary, you won't be subject to penalties, Petrecca says.

LLCs, LLPs, and the Like
Small businesses that take on a structure such as a Limited Liability Company (LLC) or a Limited Liability Partnership (LLP) are taxed at the end of the road -- on a partnership tax return, for example. They are called "pass-through" entities since the taxes are passed along and are paid by the individual rather than the corporation.

Generally all income is subject to employment taxes. However, like S Corporations, LLCs and LLPs can distribute payments to their officers. Distributions are not subject to employment taxes, Clark Nuber's Pannell says.

Of course, the same reasonable rule applies here. If the IRS thinks you're trying to avoid employment taxes by paying yourself in a distribution, it will call you on it, Pannell says.

"They'll come in and say, 'Jeff, are you the acting president of the partnership and you're not receiving any salary even though you're working full time?' " Pannell says. That's going to raise a red flag, the CPA says.

Salary being equal, an officer of a C or S corporation will pay less employment taxes than a member (officer) of an LLC will. However you'll have to measure that tax benefit against the other pro's and con's of the different corporate structures before you settle on one.

No matter which structure you choose and no matter how you choose to pay yourself, one thing is clear: one way or another, you'll be paying the taxman.

Jenny C. McCune is a contributing editor based in Montana


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See Also
Basics: How to pay yourself
Health insurance options for the self-employed (9/11/00)
LLC vs. Inc. Which legal structure is best? (8/3100)
Business overhead insurance keeps things going when you're ill (6/2/00)

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