On several occasions, the following scenario has played itself out in my office: client comes in very excited, exclaiming that they are "going out on their own". We file all the necessary paperwork to get an employer identification number, articles of incorporation, and have a quick run-through of how to keep up with income and expenses. Then, they are on their merry way.
About a month later, the client calls and asks "how do I pay myself?"
This is a common issue for small business owners, especially when they are set up in partnerships or S-Corps. To begin, partners in partnerships typically do not draw salaries, and S-Corp shareholders only draw "reasonable compensation" during the year. The remainder is taken by the partner/shareholder as a distribution, loosely defined as taking cash out of the business.
Here is an example. Jim is the 100% shareholder of Jim's Tools Inc, an S-Corp. For the year, Jim has taxable profit of $100,000. Of that, he pays himself a salary of $30,000, leaving the company with a $70,000 profit. Jim will pay taxes on both his $30,000 paycheck and the $70,000 profit of the business on his personal return. Assuming he is in the 25% tax bracket, his tax burden will be $25,000 ($30,000 paycheck + $70,000 business profit x 25% tax rate). Based on these facts, he is permitted to distribute up to $70,000 of cash from the business to himself. At the end of the day, he is left with $75,000 in his personal bank account after paying taxes.
Partnerships work in a similar way, minus the salary. The big difference is that the income from a partnership is likely to be subject to self-employment tax, since there is no salary involved. In an S-corp, the shareholder will pay self-employment tax (payroll taxes of FICA and Medicare) on their paycheck. Since a partnership does not pay a salary to the partner, the partner is responsible for this on their personal return. But, distributions work the same way: if a partner has net profit for the year of $100,000, they will pay ordinary and self-employment tax on that money, but will be permitted a distribution up to $100,000.
The main thing to remember is that S-Corps must pay a reasonable salary during the year to its shareholders, which is the tradeoff for the net earnings from the S-Corp not being subject to self-employment tax. Partnerships and S-Corps should also keep track of their distributions during the year for reporting on the tax return at the end of the year.