When you own a small business, paying yourself is more complicated than simply writing a check. Depending on how you've structured your business, you want to be on the lookout for a few serious trouble spots.
Gail Rosen, CPA, a shareholder with Wilkin & Guttenplan P.C., and a small business tax specialist, explains the four worst small business owner salary mistakes — and how you can avoid them.
1. Setting Up a W-2 Salary for the Wrong Business Structure
The first mistake is setting yourself up with a salary when it's not allowed in your business structure. "Sole proprietorships, partnerships and most LLCs are not considered separate entities from the owners. As a result, they aren't allowed to send W-2 paychecks to owners."
You shouldn't be on payroll in these cases. Instead, draw from the profits and transfer money directly to your personal bank account. "If the IRS sees a business incorrectly sending out paychecks to the owners, technically they could charge a penalty or they could just tell the business owners to stop."
Rosen points out that when business owners make this mistake, they're getting charged unnecessary payroll taxes for unemployment and state disability, since you only owe these taxes when you're receiving a salary through payroll. That's one more reason to avoid this small business owner salary mistake.
2. Miscalculating Estimated Taxes
Since you can't put yourself on payroll with sole proprietorships, partnerships and most LLCs, you don't have a payroll company automatically taking out your withholding taxes. Instead, you have to send in estimated tax payments to the IRS four times a year.
These estimated payments must add up to 90 percent of your total taxes for the current year or 100 percent of what you owed the year before — or, if your 2017 adjusted gross income exceeds $150,000 ($75,000 if you're married and filing separately), 110 percent.
Rosen sees owners run into trouble because they miscalculate how much they'll owe, fall behind or simply don't realize they owe estimated taxes. Eventually they get hit with a tax bill, possibly including extra penalties and interest.
3. Inadequate Salary From S Corporations
In an S corporation, you pay yourself a salary and the remainder is a pass-through profit or loss distribution. You owe additional payroll taxes on your salary but not on profit distributions. As a result, it's tempting to minimize your salary and pay out as much as possible in distributions.
If you don't make a profit with your S corp, you don't need to pay yourself a salary. If you are profitable, however, the IRS mandates that you pay yourself reasonable compensation from the profits. "What's reasonable? It depends on the job/industry. Think of what would it cost to hire a nonrelated person to do your work. That's a good way to estimate how much to pay yourself."
This is a mistake the IRS is focusing on. If you don't pay yourself an adequate salary, the IRS will eventually say you should have, recalculate your return as though a reasonable salary had been paid and then collect the extra taxes — plus penalties and interest.
4. Double Taxation From No C Corporation Salary
One last mistake is when owners of a C corporation don't pay themselves a salary and simply pay out all profits as dividend payments. "Dividends are taxed twice," Rosen points out. "Once at the corporate levels and again at the personal level."
C corp owners could potentially save on taxes by paying themselves a salary or a bonus from the profits. In that case, income is only taxed on the personal level. Again, the salary must reasonable for the work being done, so you can't pay yourself a disproportionately large salary to avoid the double taxation.
These are complex issues, and as always, the safest way to avoid small business owner salary mistakes is to meet with a tax professional. It's worth getting your compensation right the first time around in order to avoid the time and expense of correcting mistakes later, when you'll want your attention on other, more immediate business issues.