You're a business owner, and even if your business is your baby, you still need to pay yourself enough to keep your lights on at home and ensure you have food for the table.
Paying yourself as a business owner is not just about the money—it's also about your mental health and ability to keep going. Successful business ownership is as much about your ability to thrive financially and provide for yourself as it is about future business profits and growth.
So how do you legally pay yourself as a business owner? Well, it depends on the type of business you own. Whether you are a sole proprietorship, a partnership, or a corporation, it's essential that you reward yourself monetarily for the hard work and effort you are putting into your growing business.
Below, we’ll explain how to choose the best method for paying yourself as a business owner in a way that makes sense financially and practically for your specific situation. In the process, you can learn how to pay yourself with an owner's draw or paycheck, how each method is taxed, and when to change your business entity status.
Key Takeaways
- Owner’s draw is a way for business owners to pay themselves from their business profits in flexible amounts as they need it.
- New LLCs, partnerships, and sole proprietorships with low or inconsistent income benefit most from using owner’s draw.
- A business owner can pay themselves a salary—a fixed amount set aside to pay themselves each month or year, regardless of how much profit the business makes.
- Established S and C corporations and nonprofits generally utilize salary and dividends as owner payment methods for tax and financial stability.
Owner’s Draw vs. Salary
Pros and Cons of Owner’s Draw
This method is the best for limited liability companies (LLCs), partnerships, and sole proprietorships.
Pros
Ideal for businesses starting up with low or inconsistent cash flow
There is no tax on a draw for an LLC or any other pass-through entity
Compensation can be flexible and adjusted based on your business's performance and profitability
Perfect for businesses with cyclical or seasonal profits
A common choice for owners who don't have the business funds to pay themselves a regular salary yet
Draws can be taken out at regular intervals or on an as-needed basis
Cons
Reduces the business’s overall equity and cash flow
Easy to overdraw, cutting into your business's bottom line and future growth
Requires careful budgeting, tax planning, and recordkeeping
Taxes on the overall business profits must be self-reported (federal, state, quarterly estimated, and sometimes self-employed taxes)
If you own a C corp and take draws, you may be double taxed; first as profits and then as dividends
The IRS only allows 401(k) contributions from salaries
Pros and Cons of Salary
Also called “salary at a glance,” this method is the best for S corporations, C corporations, and nonprofit organizations.
Pros
The simplest way for business owners to pay themselves
Pays the business owner a fixed salary at regular intervals
Consistent paychecks allow owners to meet their personal expenses consistently
Ideal for more stable businesses with consistent cash flow
State and federal personal income taxes get taken out automatically
Easier for budgeting and tax planning
Financial consistency and stability of paychecks
Makes it easier to track expenses and manage cash flow
Cons
This method does not take into account any business expense fluctuations
Salary and dividends are considered personal income and taxed accordingly
It can be tricky to avoid getting double-taxed with this method
Salary amounts and adjustments must meet current guidelines for "reasonable compensation;" otherwise, it will raise red flags with the IRS
Your earnings may fluctuate, and you may not meet your salary
How To Pay Yourself From an LLC, Partnership, or Sole Proprietorship
If you are a sole proprietor or in a partnership, you must pay yourself or your partner as employees. For an LLC, the process is similar. The only significant difference is the legal separation between the LLC members and the business itself. Perhaps the best way to pay yourself for these three business structures is through the owner's draw, distributing funds as needed throughout the year as your business grows.
Note
Owner's draws are funds transfers, not personal income or wages, which means they're not taxed as such. LLCs are pass-through entities, meaning the business's taxable income is allocated directly to owners to pay on their tax returns.
Here’s how to pay yourself from an LLC, partnership, or sole proprietorship:
- Figure out how much you want to take home every year. What are your personal budgetary needs?
- Determine how much money you need for your business expenses. This includes everything from office supplies, marketing materials, and employee salaries if applicable.
- Calculate the difference between the two numbers and divide it by 12. This will give you a monthly amount to withdraw from your business account each month for personal use. This is how much your owner's draw can reasonably be without cutting into your business bottom line.
- Then, set up a dedicated bank account for funds transfers that will be used to pay your partners and yourself.
Note
If you draw excessive amounts, the IRS may consider your business an unprofitable hobby and not allow for standard business deductions, which can cost you.
How To Pay Yourself From an S Corp or C Corp
If you operate an S corporation or C corporation, there are three different processes for paying yourself as an owner. You can take home your pay through a salary, distributions, or a combination of both. The IRS has a set of rules that determine how much you can pay yourself as a business owner. These rules differ for S and C corps.
Note
Owners' salaries from S corps are considered business expenses, just like paying any other employee. Any net profit that's not being used to pay owner salaries or isn't taken out in a draw is taxed at a corporate tax rate, usually lower than personal income tax rates.
S Corporation
An S corp is a type of corporation taxed as a partnership. The business's income is passed to its shareholders as dividends. Those in an S corp are responsible for paying individual income taxes on it. S corps do not have to pay taxes on profits, but its shareholders must pay taxes on their dividends. Since S corps are structured as corporations (with shareholders), there is no owner's draw, only shareholder distributions. If you need consistent paychecks, you must take a salary as a W-2 employee.
Small businesses often use the S corp structure because it allows them to avoid double taxation. S corporations are only taxed once at the individual level when dividends are distributed to owners or shareholders. However, there are some limitations set by the IRS. If you want to take more than a reasonable salary, you must convert your S corp to a C corp or LLC.
C Corporation
A C corp is different from all the other types mentioned in that double taxation applies, wherein it pays taxes on its profits and the owner pays taxes on any dividends they receive. C corps are taxed at a higher rate than individuals but have more benefits.
- C corporations are taxed at the corporate level and then at the individual level when they distribute dividends to shareholders.
- A C corp can deduct business expenses from its taxable income, which lowers its overall tax amount.
- The IRS has no say in your salary, and it cannot deduct anything from your earnings if it exceeds the minimum wage.
The Bottom Line
Every business owner needs funds for personal expenses and living costs. Different methods are used to pay yourself depending on the type of business you own.
First, determine the type of entity your business is and how you want your business to be treated for tax purposes. Calculate how much money your business can afford to pay out in salaries, owner's draws, dividends, or distributions each year and how much you need for your personal expenses.
Finding the difference between those two amounts is essential before deciding how much money should be paid out from the business's profits. When in doubt, refer to the IRS website for specific lists of frequently asked questions on each type of business entity and payment structure.
Frequently Asked Questions (FAQs)
How do you pay yourself from a nonprofit?
The first step is setting up a nonprofit corporation—the legal entity you will use to operate your business. The next step is to set up a dedicated bank account for your nonprofit.
You will need to file articles of incorporation with the state in which you are incorporating your nonprofit. You should also apply for tax-exempt status with the IRS and Franchise Tax Board, which can take up to six months or more before approval is granted. Once that is done, similar to an S or C corp, you can pay your officers or shareholders dividends from net profits.
What is the most tax-efficient way to pay yourself?
The most tax-efficient way to pay yourself as a business owner is a combination of a salary and dividends. This will allow you to deduct the salary from your business's income and pay taxes on it. If you are not paying yourself a salary, you will have to pay taxes on the profit of your business. This can lead to a higher tax bill in the following year unless you reduce that profit by paying yourself dividends. This system works best for C corps and LLCs.
How much should you pay yourself as a business owner?
First and foremost, evaluate your business’s profitability. If your business is not profitable yet, then it might be unwise to pay yourself the sizable owner’s paycheck. Around 80% of new businesses fail because of cash flow problems. Before dipping into your cash flow, account for your business needs first, such as investing, marketing, and estimated taxes. Be sure to allocate enough cash to keep your business going, and don't pay yourself more than you can afford.
