Since you're now the proud owner of your very own company, it's time to pay your best employee: you!
There are two ways to pay yourself through your company:
- Payroll
- Distribution
When you pay yourself via payroll, you're effectively hiring yourself as an employee of your company and paying yourself a salary. You'll issue yourself a W-2 at the end of the year just like you would get if you were employed full time with another company. S Corp owners with no employees (like you!) pay themselves this way because it reduces the amount of income subject to self employment (SE) tax. We'll talk about that in a second.
The other way to get paid, through a distribution, is a little like being paid a dividend when you own stock. Because you're the sole owner of your company, you are entitled to withdraw your profits as a distribution. Distributions are taxed at your normal marginal income tax rate. This means you'll likely experience a reduction in your overall tax since you won't pay self employment tax on this money.
Your ideal mix between W-2 salaried income and distribution income will depend on the tax environment in your state. Please discuss your plan in detail with an accountant in your area.
Setting up payroll
For years, I took money from my business account whenever I wanted it. I can tell you from experience this is a bad idea. Setting up a formal payroll system offers peace of mind and a better understanding of how much "runway" you have before you can't pay your bills.
As we'll examine in the coming chapters, the biggest determinant in building wealth is your savings rate, the proportion of your income you save, compared with how much you spend.
It's important to choose a salary which not only minimizes your tax burden, but pays your monthly expenses.
By doing this, you're forcing yourself to keep enough money in your business account to make payroll each month. And believe me: It works. You need to make a commitment as a business owner to pay your employees. You'll work extra to make sure you can make payroll. It's a fun game.
We'll talk about how to max out your retirement accounts later. For now, work with your accountant to select a salary that maximizes your tax savings. We'll adjust it later to accommodate for your investing.
Choosing a payroll provider
In my search for a payroll provider, I turned up a bunch of big players. Companies like ADP offer payroll services for small businesses, but their monthly fees were high: $70 for a single employee.
Having spent quite a bit of my time in the startup scene, I knew there had to be some emerging players in the payroll market. It turns out, [Gusto] has come to the rescue! They charge $29/month and their support is excellent. I use them for my freelance business and recommend them for yours.
When to take distributions
In my mind, distributions should only ever be taken under a couple circumstances:
- It's the end of the year and you have extra money in your business account
- You've exhausted your personal savings and there's an emergency
It sounds a bit extreme, and it is: If you're covering your expenses using your "salary", distributions represent overspending. You're intending to spend money that you already said you didn't need to. Because your savings rate is the biggest factor in building wealth, this means you should avoid at all costs withdrawing from your business account and creating a taxable event.
Because you're an S Corp, though, at the end of the year whatever money is in your business account will be taxed. Because of this, it makes sense to take it as a distribution so you can invest it.
But don't I get to have any fun with my money? Well, sure! Have all the fun you want. Just remember that the more you spend, the less you save. Your savings rate is the key determinant in building wealth. So have fun wisely.
Remember that distributions are taxable, so be sure to set aside enough money in a separate savings account to pay your quarterly estimated tax. As I've already said, be sure to consult with your accountant about how much money to retain for your tax payment when taking a distribution.
Making Estimated Tax Payments
Because you'll likely have more income than you pay yourself as a salary, you'll probably need to make estimated tax payments to the IRS and your state treasury. Typically, these payments are made at the end of every fiscal quarter. As with all things tax, the details will vary depending on your jurisdiction. This book is not a substitute for an accountant.