How to pay yourself: A comprehensive guide for business owners by entity

One of the main motivations for starting a business is to generate profit. But once the profits start rolling in, how do you transfer that money into your personal bank account? The method you use to pay yourself is a critical decision that depends heavily on your business’s legal structure and your approach to taxes.

As your enterprise expands, the way you draw an income from it can, and often should, change. It's crucial to establish a proper payment system from the beginning to ensure you remain in good standing with tax authorities like the IRS.

This guide will explore the two primary methods for an owner to get paid, outlining the advantages and disadvantages of each. Understanding these options will help you choose the right path for your specific business entity.

Owner’s draw vs. salary: The two main payment methods

For any small business owner, there are fundamentally two ways to receive compensation: an owner’s draw or a formal salary. The best choice hinges on your business entity, its stage of development, the tax implications of each method, and your personal involvement in the company’s day-to-day operations.

One common approach is the owner's draw. With this method, you simply withdraw funds from your company’s profits whenever you need them. This provides significant flexibility, allowing you to take money out based on fluctuating business income and personal needs. It's a straightforward way to access your hard-earned money without a rigid payroll structure.

The alternative is the salary method. By choosing this route, you become a formal employee of your own company. You will receive a regular, predetermined wage, complete with tax withholdings, just like any other staff member. This creates a more predictable and structured financial relationship between you and your business.

The mechanics of an owner’s draw

The primary benefit of an owner's draw is its flexibility. It empowers you to tailor your compensation to the real-time performance of your business. If you have a great month, you can take a larger draw. If cash flow is tight, you can take less or nothing at all, without the formal process of adjusting a set salary.

However, the flexibility of a draw comes with a significant administrative downside. The record-keeping required can be substantial. Since draws are not taxed as personal income at the time of withdrawal, you are responsible for calculating and paying self-employment taxes on your share of the business profits. This typically involves making estimated tax payments to the IRS on a quarterly basis.

These quarterly tax obligations will vary depending on your business’s profitability, which can complicate your financial planning. It introduces an extra layer of bookkeeping, as you must meticulously track profits to ensure your tax payments are accurate.

Maintaining pristine financial records is essential when using the owner's draw method. To accurately calculate profits, you must have a clear picture of all income and expenses. Manually tracking every receipt and invoice can be a significant burden. Utilizing a tool like Zenceipt can streamline this process by automatically connecting to your email inbox and extracting financial documents, ensuring your profit calculations are always based on complete and accurate data.

The mechanics of a formal salary

Opting to pay yourself a salary provides a consistent and predictable income. Just like a traditional job, state and federal income taxes are automatically deducted from each paycheck. This simplifies your personal tax situation, as you are less likely to face a large, unexpected tax bill at the end of the year. A steady pay history can also be beneficial when applying for personal financing, such as a mortgage or car loan.

A fixed salary also simplifies your business's financial management. It becomes a predictable monthly expense, making it easier to budget and forecast your company's cash flow. The paperwork is more consistent, reducing fluctuations in your accounting workload.

The main challenge with the salary method is determining an appropriate amount. The IRS requires that your salary be "reasonable." This means your compensation should be comparable to what someone in a similar role, at a similar company, in a similar industry would earn. This rule prevents business owners from taking a very low salary to minimize payroll taxes while taking the bulk of their compensation in the form of distributions. You do have the flexibility to give yourself a bonus at year-end to supplement your income.

How to get paid from a sole proprietorship, partnership, or LLC

If your business is a sole proprietorship, a partnership, or a limited liability company (LLC), the owner's draw is the standard method for paying yourself. It involves a simple transfer of funds from the business bank account to your personal one.

For a sole proprietor or a single-member LLC, you have complete discretion over how much money you take, as long as the business has the funds to cover its obligations. There are no other partners or shareholders whose financial interests you need to consider. It’s important to note that for most LLCs, members are not legally considered employees and therefore cannot be paid a salary. The draw method is the required approach.

In a partnership or a multi-member LLC, profit distribution must follow the terms laid out in the partnership agreement. This agreement will specify the percentage of profits each partner is entitled to, such as a 50/50, 60/40, or another agreed-upon split. It is critical that these terms are followed precisely.

At the end of the year, the partnership must file a Schedule K-1 with the IRS for each partner. This form details each owner's share of the business's profits, losses, credits, and deductions. Taxes are paid on the total allocated profits, not just on the funds that were drawn throughout the year. This requires diligent planning for quarterly estimated tax payments to avoid penalties.

How to get paid from an S corporation

As the owner of an S corporation (S corp), you are legally required to take a reasonable salary. You are considered an employee of the corporation, and a formal payroll must be established. You also have the option to take additional, non-taxable distributions from the company’s profits, but these are supplementary and cannot replace a salary.

The IRS pays close attention to the salaries that S corp owners pay themselves. The "reasonable compensation" requirement is strictly enforced to ensure owners are not avoiding payroll taxes. This means you must research industry benchmarks to set a salary that would "ordinarily be paid for like services by like organizations in like circumstances." This salary should be high enough to be considered reasonable but not so high that it drains the company’s cash flow.

While you can also take shareholder distributions, these are not the same as an owner's draw. They represent a distribution of company profits, and they can only be taken after a reasonable salary has been paid. Attempting to use distributions as a substitute for a salary is a major compliance risk that could trigger an audit.

How to get paid from a C corporation

Owners of a C corporation (C corp) face the same reasonable salary requirements as those of an S corp. The company must pay you a salary that is justifiable based on your role, the industry, and the company's size and location.

In addition to a salary, C corps can issue dividend distributions to owners. However, there is a critical distinction here compared to S corps. Dividends from a C corp are taxable for the shareholder who receives them. This is a key feature of the "double taxation" structure of C corps, where the corporation pays taxes on its profits, and then the shareholders pay taxes again on the dividends they receive.

When it's time to file taxes, C corp owners handle their personal returns separately from the corporation's. The salary you receive is reported on a Form W-2, just like any other employee's wages. Since payroll taxes are withheld from each paycheck, you likely won't owe additional personal taxes on that income. However, any dividend distributions must be reported on your personal tax return, and you will owe taxes on that amount. The IRS provides clear guidelines for corporation owners on how to manage salaries and dividends correctly.

Choosing how much to pay yourself requires balancing your personal needs with the financial health of your business. If you are taking an owner’s draw, your primary focus should be on the company's available cash and planning for your tax payments. If you are setting a salary, the decision is more complex.

Here are a few factors to consider when setting your compensation:

• Company revenue: A new business with tight margins can't support the same salary as a highly profitable one.
• Personal expenses: Your income must be sufficient to cover your own living costs.
• Industry standards: Your salary should align with what others in similar positions earn to meet the IRS's "reasonable" test.
• Cost of living: Your geographic location should be a factor in determining your pay.
• Lifestyle goals: If the business is thriving, your compensation should reflect the success you've worked to achieve.

Ultimately, being your own boss means making smart, sustainable financial decisions. No matter which payment method you choose, the foundational principles are the same: maintain a strict separation between your business and personal finances, budget carefully for your tax obligations, and be consistent and transparent in your payment plan.