Payroll: How to pay yourself, legally.

May has been a busy month as we catch our breath from tax season while also trying to get out of the office and spend a little more time with our families. That hasn't left much time for blogging, but we're back in the swing of things now. Recently we've taken on some new clients who have used some pretty creative accounting techniques for payroll in the past. One of our goals is to help small businesses become big businesses and toward that end we try to bring some sophistication to their accounting practices as well as bring them into compliance with the tax laws.

The simplest type of business entity is a sole proprietorship. However, most people don't understand that these business profits are taxed twice: once for ordinary income tax and once for self employment tax. Self employment tax is nothing more than social security and medicare taxes. When you work for someone else 7.65% of your pay is withheld for social security and medicare in addition to the amounts withheld for income tax (commonly called federal withholding).The employer is also taxed 7.65% on your wages. When you go into business for yourself you get to pay both sides and the tax rate is 15.3%. Owner's of sole proprietorships don't cut themselves a paycheck. Instead they take draws from excess cash. No matter how much or how little they take out they are charged both self employment tax and income tax on the profits...even if they leave all the money in the business and take nothing for themselves.

Corporations are somewhat different. Where a sole proprietorship is not legally distinct from its owner a corporation is. Therefor a corporation must decide how much to pay those working for it and it must go through the formality of cutting a payroll check, filing payroll tax returns and depositing the corresponding payroll tax liability. If a corporation chooses to pay its employees relatively little then it will pay less payroll tax. If it pays them a lot it will expect to have a bigger payroll tax bill. IRS is wise to this and they realized a long time ago that if given the opportunity many small corporation owners wouldn't pay themselves a salary at all; they would just take dividend distributions. That is why IRS requires corporations to pay officers and owners a reasonable amount of salary. They don't give us many guidelines to determine what is reasonable, but generally we can look at the market and determine what we would need to pay an unrelated party to perform the same services and base our compensation on that.

What we have been seeing lately are corporations (specifically S corporations) where the owners are not taking any salary at all. Instead they are continuing to take draws as if they were a sole proprietor. From a federal standpoint their tax rate will be about the same if they claim these draws as self employment income on their tax return. However, because there has been no payroll they have not paid any associated state unemployment taxes. Nor have they paid any federal unemployment taxes. As quickly as possible we try to transition these owners from a 'draw' mentality to a 'payroll' mentality.

The danger in not treating your compensation properly is two fold. First, you are not adhering to the IRS rules regarding fair compensation and you are not paying the proper amount of federal or state payroll tax. Second, by treating your corporation as a sole proprietorship you may be giving up certain liability protections that are often important reasons for incorporating to begin with.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.