Are You On The Payroll?

So you've started your own business.You're making some money, and now you're starting to pay yourself. You're calling it your payroll. But is it really?

Here's the deal: If you are a sole proprietor (you have not formed a corporation or LLC, or a partnership, and will file a Schedule C or F with your form 1040), then you are not an employee of your own company. The earnings of your company will be reported as self-employment income on your individual tax return, and you will pay Social Security and Medicare taxes on the earnings as well. Any money you "pay" yourself out of the company should be shown on your financial statements as a "draw" on the balance sheet, and not "Payroll Expense" on the profit and loss.

If you have formed a regular partnership, the same rules pretty much apply. The partnership will file its own return, splitting the earnings among the partners, and that will be reported on your 1040 and the applicable taxes will be applied.

If you have formed a corporation (either S or C), then you MIGHT be an employee. Just paying yourself from the company funds does not make you an employee. To be an employee, you must calculate and withhold taxes from your paycheck, deposit those taxes (plus the company's portion) on a regular basis, and file quarterly and annual payroll tax returns. If you are just taking money out of the company without doing those activities, then you have either a "distribution" (or "dividend"), or possibly a loan.

If your company is an LLC, then things get even more complicated. An LLC is a business organization recognized by states, but not by the IRS for tax purposes. The company will elect to be treated as a corporaton or as a partnership when it files its first tax return (a single-member LLC can be either a corporation or a "Disregarded Entity", meaning the owner will file a Schedule C as a sole proprietor). If the company is taxed as a corporation, then the corporate rules mentioned above apply. If it's taxed as a partnership or sole proprietor, then the owner(s) is not an employee.

Now, if your business is set up as a corporation, which means you are eligible to be an employee, should you do this? It does add paper work and complexity. BUT, generally speaking, it is a good idea. If you are pulling a draw or distribution from your corporation but are NOT on the payroll, the IRS is likely to take a look at that and tell you that it is actually payroll, and will retroactively charge you for the payroll taxes, plus penalties and interest, that you did not sent them. You should pay yourself "reasonable compensation" and comply with the payroll reporting requirements to avoid this. "Reasonable compensation" is a fairly squishy term and it depends on what your role is in the business and how much time you spend working in that business. But you will want to pay yourself an amount that you might pay somebody else to do the same job.

There are also some potential tax advantages to treating yourself as an employee of your corporation, and you will want to consult with your tax pro to see if your situation can benefit from some of those.

So as usual when it comes to tax issues, this question does not have a simple answer. And to tell the truth, the information presented above is a simplified overview. My usual disclaimer applies--this should be taken as general advice and NOT tax advice. As always, consult with your tax professional to determine the best course of action for your particular situation.