8 Reasons Why Business Owners Should Pay Themselves by W-2 Payroll

by Randy Hayes | June 3, 2024

Running a business involves making a multitude of decisions, each of which can have significant financial and legal implications. One such critical decision for business owners is how to pay themselves. While some may opt for owner draws or distributions, there are compelling reasons why putting oneself on a W-2 payroll can be advantageous. Below are 8 reasons why business owners should consider this approach.

• Compliance with IRS Requirements: For S Corporations and C Corporations, the Internal Revenue Service (IRS) mandates that owners who are actively involved in the business must receive a reasonable salary. This salary should be commensurate with what someone in a similar position would earn. Failure to comply can result in penalties and back taxes. By placing themselves on W-2 payroll, business owners ensure they meet these IRS requirements, avoiding potential audits and fines.

• Consistent Income Stream: Being on W-2 payroll ensures a regular and predictable income. This consistency can be crucial for personal financial planning, enabling business owners to manage their personal expenses, budget effectively, and maintain a stable cash flow. It also simplifies the process of obtaining loans or mortgages, as consistent income is often a requirement for such financial products.

• Tax Benefits and Withholding: When business owners are on payroll, taxes are withheld from their paychecks automatically. This can simplify tax time, as it reduces the likelihood of owing a large sum of money to the IRS at the end of the year. Additionally, W-2 employees are eligible for certain tax benefits and deductions, such as retirement plan contributions and health insurance premiums, which can be directly deducted from their paychecks pre-tax.

• Retirement Contributions: Business owners on W-2 payroll can contribute to employer-sponsored retirement plans, such as a 401(k). These contributions not only help in building a retirement nest egg but also provide immediate tax advantages. Employers can also make matching contributions, which is a significant benefit that owner-draw methods do not offer.

• Enhanced Credibility and Professionalism: Being on a formal payroll enhances the credibility of the business. It reflects a structured and professional approach to managing the company’s finances. This can be particularly important when dealing with investors, lenders, or during any financial audits. It signals that the business is being run with a clear understanding of legal and financial obligations.

• Access to Employee Benefits: W-2 employees, including business owners, can take advantage of various employee benefits. These may include health insurance, dental and vision plans, life insurance, and other perks often available to employees. Access to such benefits can improve personal welfare and provide security, which is particularly important for small business owners who might otherwise lack affordable options.

• Simplified Record Keeping: Payroll services often provide comprehensive record-keeping tools. By being on W-2 payroll, business owners can streamline their record-keeping processes, ensuring accurate tracking of income, tax withholdings, and deductions. This can simplify the preparation of annual tax returns and financial statements, making it easier to manage the business’s financial health.

• Eligibility for Unemployment Benefits: In some states, being on W-2 payroll can make business owners eligible for unemployment benefits if the business faces financial hardship and they lose their job. While this is not a common situation, it provides an additional safety net that is not available to those who rely solely on owner draws or distributions.

While there are various ways for business owners to pay themselves, placing oneself on W-2 payroll offers numerous advantages, from ensuring IRS compliance to providing access to retirement plans and employee benefits. It also enhances financial stability and credibility, simplifies tax and record-keeping processes, and offers potential eligibility for unemployment benefits. For these reasons, business owners should seriously consider the W-2 payroll option as part of their overall financial strategy.