IRS Advice On How to Pay Yourself When You Have a Business

smallbiztax

People go into business to make money. Figuring out how to account for the money they make can be a challenge. Thankfully, the IRS has provided guidance on how to handle accounting for the money business owners make.

Here is the guidance:

The procedures for compensating yourself for your efforts in carrying on a trade or business will depend on the type of business structure you elect. Below are topics that frequently arise when new business owners ask the Internal Revenue Service questions about paying themselves.


Corporate officers

An officer of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee. Refer to “Who Are Employees?” in Publication 15-A, Employer’s Supplemental Tax Guide (PDF).

Partners

Partners are not employees and should not be issued a Form W-2 in lieu of Form 1065, Schedule K-1, for distributions or guaranteed payments from the partnership. Refer to partnerships for more information.

Dividend distributions

Any distribution to shareholders from earnings and profits is generally a dividend. However, a distribution is not a taxable dividend if it is a return of capital to the shareholder. Most distributions are in money, but they may also be in stock or other property. For information on shareholder reporting of dividends and other distributions, refer to Publication 550, Investment Income and Expenses.

Form 1099-MISC or Form W-2

You cannot designate a worker, including yourself, as an employee or independent contractor solely by the issuance of Form W-2 or Form 1099-MISC. It does not matter whether the person works full time or part time. You use Form 1099-MISC, Miscellaneous Income (PDF) to report payments to others who are not your employees. You use Form W-2 to report wages, car allowance, and other compensation for employees.

Treating employees as nonemployees

You will be liable for social security and Medicare taxes and withheld income tax if you do not deduct and withhold them because you treat an employee as a nonemployee, including yourself if you are a corporate officer, and you may be liable for a  trust fund recovery penalty. Refer toPublication 15, Circular E, Employer’s Tax Guide for details about the trust fund recovery penalty orIndependent Contractor for more information on employee classification.

Shareholder loan or officer’s compensation?

A loan by a corporation to a corporate officer should include the characteristics of a loan made at arm’s length. That is, there should be a contract with a stated interest rate, a specified length of time for repayment, and a consequence for failure to repay the loan. Collateral would also be an indication of a loan. A below-market loan is a loan which provides for no interest or interest at a rate below the federal rate that applies. If a corporation issues you, as a shareholder or an employee, a below-market loan, the lender’s payment to the borrower is treated as a gift, dividend, contribution to capital, payment of wages, or other payment, depending on the substance of the transaction.

See “Below-market interest rate loans” under Employees’ Pay / Kinds of Pay / Loans or Advances in Publication 535, Business Expenses for more information.

Reasonable compensation

Because an officer of a corporation is generally an employee with wages subject to withholding, corporate officers may question what is considered reasonable compensation for the efforts they contribute to conducting their trade or business. Wages paid to you as an officer of a corporation should generally be commensurate with your duties. Refer to “Employee’s Pay, Tests for Deducting Pay” in Publication 535, Business Expenses for more information. Public libraries may have reference sources that provide averages of compensation paid for various types of services. The Internal Revenue Service may determine that adjustments must be made to the income and expenses of tax returns for both the corporation and an individual shareholder if the officer is substantially underpaid for services provided.

Draw account

If you are a sole proprietor  or partner in a partnership, the money or other forms of payment you take from your business should be accounted for in a draw account. This helps you know what amount of benefits you have taken from the business during the year. You cannot deduct the sole proprietor s own salary or any personal withdrawals made from the business.

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Married? File Taxes Jointly

Taxes_DueDuring a recent tax filing season, a new tax client of mine openly cried at my desk because of her newly discovered $8,800 tax bill to the IRS and $2,200 tax bill to New York State. All primarily because she filed her taxes “married filing separately” instead of “married filing jointly” with her husband.

Married Filing Separately

Federal and state governments want legally married couples to file their taxes together and to encourage them governments don’t allow certain credits, deductions and exemptions for couples who file “separately.” It also puts couples who file “separately” in a higher tax bracket then those who file “jointly.”

Taxes for 1099 Independent Contract Work

My client also got the new tax bills because she worked as a 1099 independent contractor during the year outside of her normal 9-5 and did not pay taxes on that income throughout the year. $18,000 worth of self employment income.

W4 Exemptions/Allowances

To cap off her problems and to make matters worse, her job in the social services field did not take out enough in taxes every paycheck to meet her tax obligations for the year. Had she simply put zero or one on line 5 of her W-4 form, her employer would have taken out more each paycheck to meet her tax obligation.

Tax Solutions

To make my client’s life better going forward, I gave her a number of recommendations. First, I talked with her about the differences between filing separately and filing jointly. She’s going to try to work with her husband on that. Next, I gave her the necessary paperwork she’ll need to pay her estimated taxes for her self-employment.

Then, I told her to talk with her employer about changing her exemptions/allowances so she can make them as low as possible. That way more taxes are taken out of her paycheck then needed. Finally, I gave her the websites for the IRS and New York State to work out a payment plan for her outstanding debt. With all of this hopefully we’ll have a much better tax prep experience next year.

 

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