Navigating the ins and outs of owning a business can be difficult, especially as a small business owner. With limited resources and funds at your disposal, determining how to pay yourself as a small business owner is an essential step toward long-term success. But where should you start? To help you understand your options, we’ve broken down the basics for you below.
At a glance:
There are two main ways to pay yourself: salary or owner’s draw.
Your business structure determines which options are available to you.
Sole proprietors and partners generally take draws.
S corp and C corp owners must pay themselves a reasonable salary.
Taxes work very differently depending on the method you choose.
Your choices: salary vs. owner’s draw
First, let’s look at the two main ways small business owners and entrepreneurs typically pay themselves. We’ll dive into each method, explaining how each system works and the pros and cons to consider.
Option 1: Salary method
We’ll start with salary. This is the method you are probably the most familiar with. Paying yourself a salary from your business is comparable to how you would usually pay an employee. Essentially, you pay yourself through payroll on a regular schedule, just like any other employee. Federal and state income taxes are withheld, along with Social Security and Medicare taxes (FICA). As the business owner, you must also pay the employer portion of Social Security and Medicare taxes, and your company may owe federal and state unemployment taxes.
Here are the main points to consider if you choose to use the salary method:
Pros of paying yourself a salary:
More stability: Having a recurring, stable salary expense is a huge benefit when it comes to budgeting your business costs and planning for your long-term goals.
Automatic tax withholding: Paying your taxes via the salary method is a hands-off process, as your taxes are withheld upfront.
Cons of paying yourself a salary:
Less flexibility: If you own an S corporation (or are a shareholder-employee of a C corporation), you must abide by the IRS’s “reasonable compensation” requirement. This means the salary you pay yourself needs to be comparable to that of an employee working in the same role in your industry.
Option 2: Owner’s draw method
Another option available to small business owners is an owner’s draw (also known simply as a draw). When you pay yourself via owner’s draw, you essentially write yourself a check to withdraw funds from your company’s profits on an as-needed basis. Keep in mind that this method requires you to take distributions from your business profits — not revenue. Make sure you don’t confuse the two.
The amount you can withdraw and deposit into your personal bank account is also dependent on your owner’s equity, which can be determined using the following formula:
Assets (cash, inventory, equipment, etc.) – Liabilities (debts, bills, etc.) = Equity
If you decide to take draws, taxes are not automatically withheld. However, your business profits are still subject to income tax and, in most cases, self-employment tax (which covers Social Security and Medicare). Many business owners need to make quarterly estimated tax payments to avoid penalties.
So, while you don’t have to pay taxes upfront every time, you still need to be diligent in setting aside enough cash to cover your tax bills throughout the year.
Tax Tip: It’s also important to note that owner’s draws are not tax-deductible business expenses. Taking a draw does not reduce your taxable business income; it simply transfers money from your business account to your personal account.
Pros of paying yourself with owner’s draw:
More flexibility: Using this method, you have more control over how much cash you want to draw at any given time. This allows you to pay yourself based on your business performance.
Cons of paying yourself with owner’s draw:
No automatic tax withholding: Taxes are not automatically paid every time you draw, so you need to budget for your quarterly tax bill. Because of this, you must keep detailed records to ensure every transaction is accounted for and documented.
How to pay yourself based on business type
Now that you know your owner’s salary options, it’s time to decide which method makes the most sense for you and your business needs. Your legal business structure is the biggest factor to look at here. Different payment methods work best for different business entities. We’ve listed the recommended methods for each business type below.
Salary method: S corps and C corps
Owner’s draw method: Sole proprietorships, partnerships, limited liability companies (LLCs)
Note: Because taxes are not withheld automatically, many sole proprietors, partners, and single-member LLC owners must make quarterly estimated tax payments to the IRS if they expect to owe $1,000 or more in taxes for the year.
Corporations
As the owner of a corporation, you are typically required to pay yourself a salary. This is where the IRS’s “reasonable compensation” rule comes into play.
C corps
If your business is classified as a C corp, you are legally obligated to pay yourself a salary as a W-2 employee with the appropriate tax payments taken out. This is because C corps are owned by shareholders, which means their earnings are essentially “owned” by the company. If you own a C corp and want to pay yourself more money on top of your salary, it must be treated as a dividend payment.
S corps
S corps work in a similar fashion, but with a few caveats. As the owner of an S corp, you still need to pay yourself a reasonable salary (subject to payroll taxes), but you can also take distributions on top of that (not subject to payroll taxes).
This combination is one reason some small business owners elect S corp taxation. It can reduce your overall self-employment tax when structured properly. However, your salary must be reasonable, and you can’t skip payroll altogether and only take distributions. The IRS can also reclassify distributions as wages if your compensation is too low.
Other business types
It works a little differently for sole proprietorships, partnerships, and LLCs. Owners of these businesses are essentially self-employed and are not subject to the same rules as corporations.
Sole proprietors
For sole proprietorships, the draw method is your only option; you cannot legally pay yourself a salary. As a sole proprietor, your net profit (business income minus deductible business expenses) is reported on Schedule C and flows to your Form 1040 individual tax return. That net business profit (which the IRS views as your personal income) is subject to personal income tax and self-employment tax, regardless of how much money you actually withdraw from the business.
Partnerships
Partnerships are very similar. The IRS does not consider partners to be employees, so you’re once again required to take draws to pay yourself and are taxed like a sole proprietor. However, another option is available: guaranteed payments.
Guaranteed payments are payments made to partners for services or use of capital, regardless of partnership profits. They are considered ordinary income to the receiving partner and are generally subject to self-employment tax. Like draws, taxes are not automatically withheld. Since guaranteed payments are not dependent on the partnership’s income, they can be useful for the early startup years of your business when your partnership may not yet be profitable.
LLCs
LLCs are somewhat more flexible. By default, if you are the only owner of your LLC, the IRS automatically treats you as a sole proprietorship (a “disregarded entity”) for tax purposes. Multi-member LLCs are classified as partnerships but can also elect to be taxed as an S corp.
But you can choose how you want to be taxed. If you want your LLC to be taxed as a corporation, you generally file Form 8832. If you want your LLC to be taxed as an S corporation, you typically file Form 2553. If you are unsure about the tax implications of each method, it never hurts to speak to a tax professional.
How much should you pay yourself as a business owner?
Once you’ve determined the best way to pay yourself, one question remains: How much should you pay yourself as a business owner?
The answer here will look different for everyone. To help you make the best decision for your personal situation, consider these additional questions:
How is your business performing? Make sure you know your business inside and out! If you aren’t already, get familiar with your company’s financial reports and what kind of cash flow you have to work with. Remember, you need to turn enough of a profit to pay yourself a “reasonable salary” in the eyes of the IRS.
What are your expectations for business growth? Are you just starting out as a new business owner? Is your business growing quickly? If your business is rapidly expanding, you need to make sure you have enough cash on hand to invest in potential growth opportunities as they arise. In this case, you might consider paying yourself enough to cover your basic expenses and put the rest of your profits toward growing your business.
What personal expenses do you need to consider? This will look different depending on your cost of living and how many dependents you have, but it’s important to have a good understanding of your family’s basic needs and how much you can reasonably expect to live on.
FAQs
The bottom line
So, what is the best way to pay yourself as a business owner? There is no one-size-fits-all approach to this decision. In the end, the choice to take a salary or owner’s draw hinges on your business structure, your flexibility, and your personal and professional goals.
Whichever method you choose, enjoy that first pay day … you earned it!
This article is for informational purposes only and not legal or financial advice.
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