As a small business owner, how should I pay myself?

Hint: Not out of petty cash

If you’re anything like me, you started your business not only because you wanted to spend more time using your natural talents on a job you’re passionate about, but also because you wanted to make some money.

Well, after you spend all that time refining your craft, marketing, signing up clients, and delivering your work, you finally have some cash coming in.  So the question becomes, how do you get paid for your work? Do you cut yourself a paycheck like you received when you were an employee, or will you have to find some other method to get money into your bank account?

In a nutshell, to pay yourself simply write yourself a check or set up a wire transfer from your business bank account to your personal bank account. (You do have separate business and personal accounts, don’t you?)

Accounting for your paychecks

OK, maybe you understood that was how you paid yourself, but you want to know about the accounting. The first thing to keep in mind is that this is not a salary expense, and you cannot deduct what you pay yourself as a business expense.  Why? Because the IRS sees the owner of a business paying himself as just a transfer of funds from one account (their business account) to another (their personal account). Therefore, there is no tax-deductible expense.

In your accounting records, the equity accounts are the accounts that show how much money the owner would be able to take from the business if they were to sell off all their assets and pay off all the money owed to other businesses and people. Contributions by the owners and income from the business increase these equity accounts, and  owner withdraws and business losses decrease them.

How are you taxed on your self-employment income?

So does this mean that business owners get out of paying the taxes that the typical employee would pay? Not by a long shot. Sole proprietor and LLCs report all the income from their business on Schedule C of their tax return. This income then rolls on to the business owner’s 1040 form, where the usual tax is calculated.

So how is this different than how it worked when you were an employee getting a W-2? Simply put, you owe more tax. The business owner also has to pay self-employment taxes.  When you’re completing your Schedule C, you’ll also complete form 1040-SE. That form is used to calculate your self-employment taxes. These taxes are the equivalent to the FICA taxes — for Social Security and Medicare — you see on a paycheck.

Additionally, when you’re an employee and get a regular paycheck, taxes are taken out with every check — so that when tax time rolls around, you aren’t hit with a big bill all at once.  When you’re a business owner, unless you make quarterly payments, you’ll owe taxes on your entire year’s income when you file your return.

There definitely are differences in how you get paid when you’re a business owner versus an employee.  Make sure you understand them before you write yourself a check.  A smart first move: ask an accountant if you have questions about paying yourself! And ask sooner rather than later so you don’t end up with an unexpected tax bill!

The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.


Image by: Koizin via Compfight cc

Chris Peden
Chris Peden, CPA, CMA, CFM has spent more than 15 years in the corporate world helping companies meet their regulatory compliance requirements. He also assists small business owners with organizing and making sense of their finance information.