How To Pay Yourself as a Business Owner: Key Takeaways

• Business owners have several choices when it comes to how they pay themselves, including owner’s draw and formal payroll. 
• Choosing the right business structure can save money on taxes.
• However, failing to pay reasonable compensation or payroll taxes when required can be costly. 

One of the key decisions small business owners need to make is how to pay themselves. How, when, and how much to pay yourself isn’t always a simple decision. You need to understand your options—and any requirements—to make sure you pay yourself properly. 

Ways To Pay Yourself as a Business Owner

There are two main ways that most business owners pay themselves: through formal payroll (salary) and/or owner’s draw which is sometimes also referred to as owner’s equity. 

What’s the difference?

If you are a business owner who pays yourself a salary, you must withhold local, state, and/or federal payroll taxes, income taxes, and unemployment, if required. 

Certain types of business structures require paying yourself reasonable compensation as a business owner. 

With owner’s draw, you take withdrawals from business profits when you choose. This does not have to be on a set schedule. Note that owner’s draw is sometimes referred to as dividends or distributions, though if you search the IRS website for dividends, it usually refers to distributions of property for stockholders in a corporation, and the IRS usually refers to distributions in the context of retirement account distributions.) 

Your available options will depend largely on your business structure and how your business elects to be taxed. 

Salary/Wages:

• You pay yourself a set amount on a regular schedule
• You must withhold taxes, including payroll and income taxes
• Some business structures require you to pay yourself “reasonable compensation”

Owner’s draw:

• Take money from business profits when you choose.
• No set schedule for withdrawals.
• Taxes are not withheld from owner’s draw (but still taxable).

Your business structure and tax elections determine which options are available to you. (More on that in a moment.) 

Eric Rosenberg works as a freelance financial writer and also operates a small software startup to help freelancers manage their administrative needs. He operates his business as a corporation taxed as an S corporation. 

“As an S Corporation, I get paid in two different ways. I have payroll running that pays me a salary every Friday, including the handling of self-employment taxes and other payroll taxes,” he explains. Rosenberg also pays himself through owner’s draw or distributions. 

Business Structures and Their Impact on Owner Compensation

The legal structure of your business will impact how you receive compensation from the business. There are four main types of business structures:

Sole Proprietorship

A sole proprietorship is an unincorporated business operated by an individual. It’s not a formal legal business structure, and the majority of US-based very small businesses operate as sole props. So do most freelancers and independent contractors, though they may choose to form a business entity. 

As a sole proprietor, there’s no legal distinction between you and your business. Operating this way, business owners are personally liable for all business debts and it exposes them to higher levels of liability than other business structures.

Paying yourself: You can pay yourself via owner’s draw. You don’t have to follow a fixed schedule, and you can pay yourself as little or as much as you want from business profits. (Profit generally refers to what’s left over after the business pays its expenses.) 

Most sole proprietors report business income and expenses are reported on Schedule C, which is filed with personal tax income returns. Self-employed individuals usually must pay self-employment (SE) tax—a Social Security and Medicare tax primarily for individuals who work for themselves—as well as income tax. 

As a sole proprietor, you won’t have payroll taxes or income taxes withheld from a paycheck, so typically you must pay quarterly estimated taxes.

Corporation

A corporation is its own legal entity, separate from the owner, that provides limited liability to shareholders. When you set up a corporation you can elect to be taxed as a C-corp or an S-corp. 

Paying yourself: Businesses that operate as a C corporation or S corporation must pay employees via payroll. 

Owners employed by a C corporation must pay themselves a reasonable salary, and may also be paid through dividends, which corporations pay to stockholders.

Owners of a business entity taxed as an S corp must pay themselves a reasonable salary, and can also pay themselves additional compensation as owner’s draw. You must be careful to pay yourself reasonable compensation, and not just rely on owner’s draw to reduce payroll taxes. 

Limited Liability Company

A limited liability company (LLC) provides limited liability to the owners (members) while also providing different management and taxation options.

LLCs may be taxed in several different ways; as a corporation, partnership, or as part of the owner’s tax return (a disregarded entity). An LLC with only one member (a single member LLC) is automatically treated as a disregarded entity (similar to a sole proprietorship) for tax purposes, but LLC’s may also elect to be taxed as a corporation. (Electing to be taxed as an S-corp is a popular choice for many LLC owners.) 

 A domestic LLC with at least two members is by default classified as a partnership for federal income tax purposes, but also can elect to be taxed as a corporation. 

Paying yourself: If an LLC has elected to be taxed as a corporation (S corp or C corp), it  must pay employee wages via payroll, and owners generally must pay themselves a reasonable salary for the work they do in the business. Owners of an LLC taxed as an S corporation may also take owner’s draw, and shareholders of C corporations may also earn dividends. 

Partnership

A partnership business structure is when two or more people control the business and are personally liable for all business debts. It’s a pass through entity, which means profits or losses flow through to the partner’s personal income tax returns. 

This is one of the more risky business structures, as a partner can be liable for debt the other partner incurs for the business, even if they weren’t aware of it. 

Paying yourself: Partners are not employees, and they aren’t paid W-2 reportable wages. Instead they receive distributions or guaranteed payments from the partnership, which are then reported on a Form 1065, Schedule K-1.

What To Consider When Determining Your Compensation

Determining your compensation also depends in part on your business structure. If your business is not taxed as a corporation, you generally don’t have to worry about whether your “salary” (or owner’s draw) is reasonable or not. You can simply take what you need. 

That said, you do need to keep in mind how much profit your business is making or you could wind up needing to take out a small business loan to cover the difference. 

For businesses that must pay a reasonable salary, you need to be extra careful to stay out of trouble with the IRS. This means checking what others in similar positions make, for example, and using that as an anchor for your salary. You may still go higher or lower than this number but it should be in line with the salaries people are earning for the type of work you do, and you should be able to justify your salary. 

The IRS can reclassify payments made to shareholders from non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes), and that could mean an unexpected tax bill. 

Setting up a Payroll System for Yourself

If your business needs to run payroll (even as a single member LLC taxed as an s corp) running payroll properly is crucial. A proper payroll system ensures you meet legal obligations and manage your finances effectively.

Payroll involves more than just how much you pay yourself. It includes withholding the correct taxes, making tax payments on time, and filing required forms. Mistakes can result in expensive penalties. For example, failing to send W-2 forms on time or neglecting payroll taxes can result in fines from state and federal taxing authorities.

To simplify this process, consider using payroll software or a payroll service. These services can help you set up your payroll properly as well as manage tax withholdings and filing requirements. 

Some services offer full management of your payroll, while others provide software for you to handle it yourself with support when needed. Choosing the right option depends on your comfort level with financial tasks and the complexity of your business.

Mistakes To Avoid When Paying Yourself

As a business owner, how you pay yourself can significantly impact both your personal finances and your company’s health. Here are some key mistakes to avoid:

Mixing personal and business finances

One of the biggest errors is failing to separate personal and business accounts. This can lead to accounting and tax headaches. 

Open a separate business checking account and use it exclusively for business transactions.

Do not pay personal expenses from your business account. Pay yourself through one or more of the methods listed here, then pay personal expenses using a personal bank account, personal debit card, and/or personal credit card.

This simple step alone makes it easier to track expenses, track cash flow and profitability, prepare tax returns, and maintain clear financial records.

Winging it

Think carefully through your compensation options and get advice to make the right choice for your business. 

“If you’re a side hustler or only work in your business part time, I would try to keep things as simple and low cost as possible,” suggests Rosenberg. “Regardless, it’s critical to track your business income and expenses so you know how much you’ve earned. Good financial records help with both taxes and making better business decisions.”

“As your business grows, if you can earn a full-time income, seriously consider becoming an LLC taxed as an S Corp,” Rosenberg advises. “This type of taxation requires more work to administer, and the costs of a payroll provider or payroll software. But as your business income grows, it can easily lead to many thousands of dollars in tax savings.”

To find the right balance, consider your business’s profits, operating expenses, and plans for growth. And don’t hesitate to review your options with an accounting or tax professional. 

Not planning for taxes

Failing to plan for taxes is a common and costly mistake. Whether you’re taking a salary or owner’s draws, set aside money for taxes with each payment to yourself. If you’re operating as an S corporation or LLC, be aware of the specific tax rules that apply to your business structure. Consult with a tax professional to ensure you’re meeting all your tax obligations.

R.J. Weiss, CFP® and CEO of The Ways to Wealth, a personal finance education company, formed a limited liability company (LLC) and elected to be taxed as an S corporation. “I pay myself a reasonable salary, which includes 401(k) contributions from the company,” he notes. “I then take small quarterly draws from the company of profit. Once taxes are filed for the year, I’ll take a more significant quarterly draw.” 

“Set aside 40% of your profits to pay taxes—yes, 40%,” advises Weiss. “You don’t want to underestimate this, as a lack of cash flow from paying a large and unexpected tax bill can ruin a business.” He says he speaks from experience. “I give the advice I gave because I had to learn the hard lesson of not setting aside enough taxes myself!” he says. “Most business owners have made the same mistake, some more damaging than others.” 

Inconsistent payments

Paying yourself irregularly can complicate both business and personal financial planning. Establish a consistent payment schedule, even if the amounts vary based on business performance.

Overlooking retirement savings

Also, don’t forget about your future – set up a retirement account and make regular contributions. Options like a SEP IRA or Solo 401(k) can help you save for retirement while potentially reducing your current tax burden.

By avoiding these mistakes, you can create a payment strategy that supports both your personal financial goals and your business’s long-term success. Remember to review your approach periodically as your business grows and changes.

Strategies for Maximizing Your Compensation While Minimizing Tax Liability

As a business owner, you can use several strategies to boost your compensation while keeping your tax burden in check. Here are some effective approaches:

Take advantage of all possible deductions. Know which expenses you can write off and use them. For example, if you work from home, you might qualify for a home office deduction. Employee salaries, business travel, and equipment purchases are other common deductions. By reducing your taxable business income, you can lower your overall tax bill.

Read: Top Tax Deductions in 2024

Keep your personal and business finances separate. This advice is worth mentioning again. It not only simplifies tax preparation but also protects you if your business faces financial difficulties. Use a business bank account and business credit cards for business transactions. This makes it easier to track business expenses and income accurately.

Review your business structure periodically. Your company’s legal structure can significantly impact your taxes. As your business grows, the best structure for you might change. Periodically consult with a tax professional to ensure your business structure still fits your needs.

Don’t overlook retirement accounts. Setting up and contributing to retirement accounts can provide dual benefits. Many retirement contributions are tax-deductible, reducing your current tax liability. Plus you’re helping to secure your financial future. Consider options like a SEP IRA or Solo 401(k), which are designed for small business owners and self-employed individuals.

Remember, tax laws change frequently, so it’s wise to stay informed or work with a tax professional to ensure you’re making the most of available opportunities.

When and How To Adjust Your Compensation

As a business owner, it’s important to review your compensation regularly, just as you would expect in a traditional job. Evaluate your pay annually or when your business experiences significant changes, such as rapid growth or shifts in your responsibilities.

To start the process, consider your role in the company. What job title best describes your current duties? Once you’ve determined this, research salary ranges for similar positions in your area. This gives you a baseline for comparison. 

However, don’t stop there. Take into account your unique circumstances:

1. Your experience level
2. The full scope of your responsibilities
3. Your business’s financial health and future plans
4. How changes in your income might affect your tax situation

Remember, your compensation isn’t just about salary. Consider other forms of payment, like bonuses or profit-sharing, that might align better with your business goals.

When it’s time to adjust your pay, the process will depend on your business structure. If you’re a sole proprietor, you have more flexibility. For partnerships or corporations, you may need to consult with co-owners or board members. In all cases, document your decision-making process and the reasons for any changes.

By regularly reviewing and adjusting your compensation, you ensure that your pay remains fair and in line with your business’s growth and your personal financial needs. This practice also helps you stay motivated and focused on your company’s long-term success.

Are You Considered a Business Owner in the Eyes of the IRS

Understanding how the IRS views your activities is crucial for tax purposes and legal compliance. The IRS considers 11 factors to determine whether your activities qualify as a business or a hobby. This distinction affects how you report income and claim expenses.

These factors include:

1. Whether you depend on the income for your livelihood
2. If you’ve made a profit in the past or can expect to in the future
3. The time and effort you put into the activity
4. Your expertise in the field
5. Your success in similar activities

While the IRS doesn’t provide a strict formula for interpreting these factors, they expect you to make an honest assessment. If you’re unsure, consider how your activity aligns with these criteria. Do you keep accurate records? Have you changed your methods to improve profitability? These questions can help guide your decision.

Remember, even if you classify your activity as a hobby and make a profit, you must still report that income to the IRS. However, the tax implications and ability to deduct expenses differ significantly between hobbies and businesses.

When in doubt, consulting with a tax professional can help ensure you’re on the right track.

“One of the biggest mistakes I see is not closely tracking income and expenses for brand new and side hustle businesses,” says Rosenberg.

“If you’re making money through a product or service, treat it like a business,” he says. “With good information, you’re in the best position to make the right decisions to grow your profits for years to come.”

When To Seek Professional Advice: Legal and Tax Considerations

Navigating how to pay yourself as a business owner can sometimes require the help of legal or tax professionals. First, they can help you choose the right business structure. Then they can help you continue to choose the right structure as your business grows, and to reduce taxes. 

It’s also a good idea to consult an expert if you’re unsure how to properly calculate your salary or distributions. As mentioned, paying yourself too little could raise red flags with the IRS, while paying yourself too much might result in taxes on excess distributions. 

A tax advisor can help you find the right balance and ensure you’re meeting IRS requirements.

If your business starts generating significant profits or you’re considering paying yourself in ways beyond a salary—like dividends, bonuses, or stock options—this is another moment to seek guidance. These forms of payment have different tax implications, and missteps could lead to costly penalties or unnecessary tax burdens. A professional can help you optimize your compensation strategy to align with your business goals while minimizing tax liabilities.

Finally, as your business grows, the legal and tax landscape will likely change. Periodically consulting with a professional can help you stay compliant with evolving regulations and adjust your payment strategy accordingly. Even if you feel confident handling things yourself, having an expert review your approach can provide peace of mind and help prevent any costly errors down the road.