Part of the series: 10 Small Business Tax Mistakes (Based on IRS Guidance)
How business owners pay themselves depends on the business’s legal structure. Different entity types have different rules for compensation and tax reporting.
IRS guidance explains that sole proprietors, partners, and S corporation owners follow different rules when paying themselves from the business. These rules affect how income is reported and whether payroll taxes apply.
When compensation is handled incorrectly, it can lead to reporting errors, payroll tax issues, or compliance problems.
Why This Happens
Many small business owners assume they can simply transfer money from the business account to their personal account as needed.
However, the correct method of compensation depends on the structure of the business, such as a sole proprietorship, partnership, or S corporation.
Without understanding the rules for their specific entity type, business owners may unintentionally handle compensation incorrectly.
IRS Requirements
The IRS provides guidance for how different business structures report owner compensation.
For example, sole proprietors generally take an owner’s draw, while S corporation owners who work in the business may be required to take reasonable compensation as wages.
These rules determine how income is reported and how employment taxes may apply.
Why This Creates Problems
- Incorrect tax reporting
Improper compensation methods can cause income to be reported incorrectly.
- Payroll tax issues
If wages are required but not paid correctly, payroll tax obligations may not be met.
- Compliance risks
Improper compensation structures can lead to adjustments, penalties, or additional scrutiny.
Best Practices
Business owners should understand how their specific entity type requires compensation to be handled.
Maintaining clear records of owner payments and separating wages from distributions helps ensure accurate reporting.
Reviewing IRS guidance or working with a qualified tax professional can help confirm that compensation is structured correctly.
Steps to Take
- Identify the legal structure of your business.
- Review IRS guidance on compensation rules for that entity type.
- Maintain clear records of owner draws, wages, or distributions.
- Consult a tax professional if compensation rules are unclear.