Small Business Payroll

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Payroll is actually a big step for a small business person or startup. There are a lot of administrative duties around payroll even when you are outsourcing the function.

For that reason, I strongly recommend using an outsourced firm for small business payroll even if you are the lone employee. Outsourced payroll services are inexpensive and there are a number of options available to lower the expense.

So the good news is that there are a number of competent firms to help you with payroll. But the bad news is: You have to pay the employer portion of payroll taxes.

What does that mean? Read on.

You already know that taxes are taken out of your paycheck whenever you got paid working for other people. Everyone knows that. These taxes include Federal, state, local, Medicare, Social Security, FUTA (unemployment tax), etc.

What is less commonly known to the new business person is that the employer (this is now you) also matches and pays some of these taxes whenever a payroll is made.

I’ll bet that’s not information you realized when prior employers were paying you. And now that you are the employer you will need to pay this matching tax for your small business payroll.

The amount that you will have to pay for the privilege of making payroll is equal to the amount that is deducted from a paycheck for Medicare and Social Security tax (a.k.a. FICA.) So if you (the employee) pay $500 of FICA, you (the employer) also have to pay $500 of FICA.

Additionally, you will have to pay a for Federal and State Unemployment tax (FUTA.) This is an amount of money used to fund unemployment.

In my experience, the total amount of matching taxes usually comes out to about 10% of what you are paying in payroll. So if you are paying $10,000 in wages, you should expect to pay about $11,000 in total payroll.

This is one of the most painful things about paying yourself properly with your small business payroll. You have to pay this extra tax on top of the regular payroll taxes that will be coming out of your paycheck. Of course, if you have any employees you will also be paying this "matching" tax for the employees.

You may ask, If paying myself via payroll is more expensive, why do it?

Good question. First, you should be aware that there are alternatives to paying yourself a salary through payroll. For example:

In Corporations you can pay yourself a dividend
In a Sole Proprietorship you take a draw
In a Partnership you can pay yourself a profit distribution

Each of these methods of receiving money from your company do not require the employers portion of payroll tax and are therefore a cheaper way of paying yourself.

But do remember that when you compile your tax return, you will have to pay income, Medicare, and Social Security taxes. That’s important because you'll need to "save" money to cover those taxes.

So now you're thinking, "Great, that's what I'll do then!" That leads me to my second small business payroll point:

The IRS is onto you. They know that you get to avoid this extra payroll tax by taking money out this way. Therefore, they keep a lookout for small business owners who are not paying themselves a "reasonable" salary via payroll.

So even if you do pay yourself a salary and also take profits, the IRS scrutinizes how much you took of each to determine if you are trying to avoid the employer payroll tax.

Therefore, at some point, you must bite the bullet, pay yourself via payroll and pay that extra payroll tax.

Now your question becomes, How much do you pay yourself in payroll and how much can you draw for yourself from profits?

I have followed different advice in this regard and base this answer on the opinion of the various accountants I have had throughout the years.

How much does the IRS expect you to pay yourself in payroll?

There doesn’t appear to be any hard and fast rule. Some suggestions I have seen over the years regarding payroll information:

Pay yourself no more than 40% of total compensation in profit distributions. So 60% of total compensation is payroll.
Your salary should be more than your profit distributions. So salary at least 51% of total compensation.
Pay yourself a salary equal to market rates and take the rest in profit distributions.
Pay yourself a salary equal to the amount of time you spend in the business (if you are part time) and at market rates. Take the rest as profit distributions.
Pay yourself a minimal salary that is "safe" given a small, start-up business situation that must conserve cash. If you are fortunate enough to build up excess profits that are safe to distribute, then pay them to yourself (and/or partners.)

Regardless of which method you choose to allocate payroll versus distributions, you should have a reasonable rationale. The reason is that the IRS will want to hear it in an audit.

For Operational Payroll Information please go here. This section will cover important operational details about payroll.

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