If you’re like most business owners, you look forward to the day you can finally enjoy taking money out of your business without worrying. However, before you head to the atm and start withdrawing money, you need to be aware of the tax implications of pulling money out of your company.
There are two primary ways to take money out of your company: a salary and a distribution. Each method retains advantages and disadvantages, making it important to consider all factors before making a decision.
What is a Salary?
A salary is money distributed to you through payroll. Like any other employee, you will receive a set amount with payroll taxes withheld. This also gives you the opportunity to participate in benefits without footing the bill from your personal account, like health insurance and retirement contributions.
If you already have employees, establishing a salary won’t require many extra steps. On the contrary, if you are the sole individual working in the company, you will need to determine a pay schedule, register with regulatory agencies, and withhold and remit taxes on a regular basis.
The IRS does limit the compensation owners can take in the form of a salary. Your salary should be reasonable based on the duties you perform. Although this can be subjective, you shouldn’t be paying yourself $200 an hour to go golfing with clients.
In addition, salaries do require your business to pay payroll taxes, which can include social security, medicare, and unemployment. However, you can deduct these expenses on your business tax return.
What is a Distribution?
Unlike a salary, a distribution does not follow a fixed schedule and can be taken at any time. This gives you more flexibility if you need quick cash from the atm or an amount larger than your salary.
Distributions are generally non-taxable returns on capital, depending on your basis in the business. Your basis includes everything you have contributed and withdrawn from the company and that you’ve earned or lost in past years.
Let’s say you have a basis of $5,000 and you take a $9,000 distribution. The $4,000 that exceeds your basis of $5,000 would need to be reported as income. This can increase your tax bill, which is why many business owners need to understand their basis in the company.
What are the Advantages and Disadvantages of a Salary?
A salary retains advantages and disadvantages. The first advantage of a salary is that it provides stability to your income stream. You can count on being paid according to your pay schedule, reducing the risk of forgetting to withdraw money or not being able to make it to the bank.
In addition, the amount you receive in social security during retirement is based on the taxes you paid during your lifetime. By taking a salary, you are able to increase the amount you receive each month, acting as a form of retirement income. Moreover, a salary can also lower your taxable business income. The wages and employer taxes paid are qualifying business deductions, reducing the amount of taxable income reported.
Despite the benefits, taking a salary does come with more work needed on the backend. The IRS and other state agencies require employers to remit payroll taxes from employee paychecks. These amounts plus employer taxes must then be remitted to each agency by a certain date, which could be bi-weekly or monthly. This results in more planning to meet deadlines and stay in compliance with regulatory agencies.
What are the Advantages and Disadvantages of a Distribution?
Taking a distribution from your company also generates tax advantages and disadvantages. The first benefit of taking a distribution over a salary is that you can generally avoid taxes. Distributions aren’t taxable to your business or on your individual return unless you exceed your basis. A tax-free return of capital can minimize your tax liability.
Distributions can also be taken whenever you need money. A salary should follow a pre-determined pay schedule, while distributions are at your discretion. If you need extra cash on short-term notice, you can easily go and withdraw money. However, it’s important that you keep track of the amounts you withdraw to make sure you stay within your basic limits.
The top disadvantage of a distribution is potential taxes on excess withdrawals. Depending on your tax bracket, you could see taxes up to 37% on the money taken out. Moreover, distributions don’t contribute to your social security fund and are not deductible on your business tax returns.
Choosing the Right One
So, which option do you choose? Most business owners see the most benefits by taking a combination of a salary and distribution. This allows you to enjoy the tax deduction associated with a regular salary while minimizing taxes with tax-free distributions.
When it comes to determining the salary amount to take each month, you want to understand your cash flow. If your business generally only gets paid once a month, it can be difficult to meet weekly payroll obligations. Your pay schedule should be determined by your cash inflows to ensure that you have enough liquidity to pay payroll taxes in addition to the salary amount.
Also, be sure that your salary is reasonable for the jobs being performed. If the IRS determines your salary amount is unreasonable, they could disallow the business deduction and assess back taxes. Compare industry data to determine a reasonable salary.
Once you have your salary established, supplement any additional income needs through distributions. Be sure you properly categorize distributions to the equity section of your balance sheet. Your accountant will need to report this information when you file your business return and to track your basis in the company.
Next Steps
The good news is that you don’t need to figure out how much of a salary to take or what amounts you can withdraw tax-free alone. Our team at Bookkeepme can work alongside you throughout the entire process, ensuring you are maximizing the income you receive and minimizing your tax liability. Reach out to a team member today to learn more.
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