How Business Owners Pay Themselves
The way business owners pay themselves depends on the legal form of their business.
Sole Proprietorship:
If a business operates as a sole proprietorship, the owner is considered self-employed, and not an employee of the business. As such, the owner simply takes a draw or distribution whenever they need money. Note that this draw or distribution is NOT an expense and is NOT a tax deduction for the business.
General Partners in a Partnership and Members in a Limited Liability Company Treated as a General Partnehship:
General partners in a partnership (and members in a Limited Liability Company) are considered self-employed and are not an employee of their partnership (or Limited Liablity Company). The partnership (or Limited Liability Company) can pay the general partner (or LLC member) a "guaranteed payment" for their services. Guaranteed payments ARE tax deductible by the partnership (or LLC) and are subject to self-employment tax for the partner (or member) receiving such payment.
Guaranteed payments are reported on each partners (or members) Schedule K-1, Form 1065, along with any items of income, deduction, and credits. Schedule K-1 is used by the recipient to prepare their individual income taxes.
Shareholders in a C Corporation or S Corporation:
Shareholders (or owners) of each type of corporation, who perform services for their corporation, ARE employees of their corporation. As such, they MUST take a reasonable amount of compensation for their services. Their compensation, treated as a salary or wage, is subject to both federal and state payroll taxes. At the end of the year, they will receive a Form W-2 just like other employees, which is used for the recipient's personal income tax return.
TAX TIP:
Corporation shareholders-owners CANNOT avoid payroll taxes by taking shareholder distributions instead of a salary or wage. This is a high IRS audit area.
NOTE: Partner and Shareholder Distributions are NOT an expense and are NOT tax deductible. They reduce the partner's outside basis in the partnership and reduce the shareholder's stock basis in the corporation. EXCESS Distributions may even create a taxable capital gain for the partner or shareholder in they have insufficient basis. Both partners and shareholders should track their ownership basis each year as this is used to determine the loss deduction allowed if the business has a loss and the calculation of gain or loss upon the sale of their interest in the business,