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Listen in! Pick up some expert advice to a reader's question that we selected from CyberSchmooz.

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Featured Biz Question

As the owner and manager of my business, I contract all my labor and pay as I go a set fee per piece. (I design and manufacture clothes for breast-feeding women in a wholesale market and single orders.) I find it difficult to pay myself. I don't know what is realistic (currently 25% of sales). I have been asking around what is best in terms of taxes (so far no answer). I'm listed as an LLC and all profits flow through my income tax. Do most business owners pay themselves on the books or just take money as it comes in? How much do they leave to run the business and leave for further business investments within their company? Thanks, Stephanie

Answer from our Guest Expert Peter Hupalo of Hupalo Ltd.

Paying Yourself

Hi Stephanie,

Great question! You're not the only biz owner out there who's not sure how to pay yourself. Figuring out how to pay yourself largely depends upon your business structure. I see you're an LLC, but I'll also try to generalize my answer to cover the most common business structures to help you determine the best way to pay yourself from the business and to help others do the same. (When in doubt, however, it's best to consult your business accountant or business attorney.)

Your Business Structure Is a Big Piece of the Paying Yourself Puzzle

First, the IRS doesn't consider sole proprietors and partners in partnerships employees; they're business owners. In corporations, however, any corporate owner who provides services to the corporation is usually considered an employee. So, if you're a corporate owner, you'd simply use the same procedures to pay yourself as you do with your non-owner employees.

If your limited liability company (LLC) has more than one owner, you can choose to have the company taxed as either a corporation or a partnership. In the case of a single owner of an LLC, you can choose to have the company taxed as either a corporation or a sole proprietorship. Because income flows through to you, Stephanie, from a tax standpoint, you've chosen to have your LLC taxed as a sole proprietorship (if you're the only owner) or as a partnership (if there's more than one owner). This is usually what most small business owners want. As you note, any profits flow through to your personal income taxes and you pay personal income tax on any net earnings of your business. So when you withdraw money from your LLC, it's a personal draw of funds that have been previously taxed. The actual withdrawal of funds for personal use is not a taxable event. The money was taxed when it was earned.

On the flip side, sole proprietors and partners may be liable for self-employment tax, which is the equivalent of Social Security tax that employees pay. (See IRS Publication 533 for more information about self-employment taxes.) There is a self-employment tax deduction which says that you may deduct one-half of your self-employment taxes from your personal income taxes, which will slightly reduce your income taxes. But, as a sole proprietor, usually any net earnings are subject to this self-employment tax, which currently runs about 15%.

If you're a sole proprietor, it's entirely up to you how much profit you remove from your business and spend on personal items. You and your company are considered the same economic entity. If you're in a partnership, the situation is more complex, because one partner might not like seeing the other partner raid the partnership piggybank. In partnerships and LLCs with multiple owners (and especially investors), how profits are allocated is set by the articles of organization.

So, the answer to your question in terms of what's best with regard to taxes is that it doesn't really matter. Your tax situation was determined when you determined your business structure. You will pay taxes as a sole proprietor (or a partner) on your net profits.

In fact, taxation is an overriding issue when choosing a business structure. continued

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About the Expert

Peter Hupalo
Owner of HCM Publishing, Inc.
Peter investigates the latest computer-programming technologies and researches companies for investment. He also writes a column about entrepreneurship and small business for iSyndicate.com and reviews biz books. Peter wrote Thinking Like An Entrepreneur, about how to make savvy business decisions and take real control of your financial destiny. more