How to Pay Yourself as a Business Owner, (Finally) Explained
As an entrepreneur, you've probably wondered about how to pay yourself as a business owner many times. It can sometimes feel like you have to choose between paying your bills (and living your life) and the growth of your business.
To complicate things further, understanding how paying yourself impacts your taxes can be, for the lack of a better expression, confusing as heck.
Many small business owners struggle with this, but don't worry. In this guide, you'll learn how to pay yourself as a small business owner to stay safe on the legal side of things as well as maximize your tax benefits.
Business Structures and What They Have to Do with Your Entrepreneur Salary
Your business structure - the way you legally set up your business - plays a big role in how you can pay yourself and the tax implications of those payments.
The most common business structures are:
Sole Proprietorships
Partnerships
Limited Liability Companies (LLCs)
S-Corporations
C-Corporations
Each of these structures comes with unique rules and considerations for how business owners can pay themselves.
Sole Proprietorships and Partnerships
In a sole proprietorship or partnership, you and your business are considered one and the same for tax purposes. This simplifies things in some ways (and complicates them in others).
As a sole proprietor or partner, you don't get paid a salary in the traditional sense. Instead, you take the owner's draws from your business profits.
The main advantage here is flexibility. You can take money out of your business whenever you need.
But you also have to pay taxes on your total business profit, regardless of how much you actually take out for personal use.
As a sole proprietor, you need to make sure to set aside money for taxes. They won't be automatically withheld from your draws. This can make things a little complicated, so it's important to plan carefully.
LLCs
The default tax treatment for a single-member LLC is the same as a sole proprietorship (multi-member LLCs are treated like partnerships).
This means that typically, you can take an owner's draw for your personal finances out of your business profit whenever you want.
That said, LLCs have the option to elect to be taxed as a corporation (either S-Corp or C-Corp). This impacts how business owners pay themselves and comes with certain tax implications.
S-Corporations
S-Corporations have a unique advantage when it comes to owner compensation.
As an S-Corp owner, you're required to pay yourself a "reasonable salary" if you're actively involved in running the business. This salary is subject to payroll taxes (Social Security and Medicare).
After paying yourself a reasonable salary, you can distribute additional profits as dividends. These dividends aren't subject to payroll taxes, which can help you save more of your business income during tax season.
But it's important to strike the right balance – the IRS keeps a close eye on S-Corps to make sure owners aren't underpaying themselves to avoid payroll taxes.
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C-Corporations
Bigger businesses typically run as C-Corps.
As a C-Corp owner, you can receive both a salary and dividends.
Your salary is a business expense for the corporation and you have to pay payroll taxes on it. Dividends are paid from the company's after-tax profits.
This creates a "double taxation" scenario. The corporation pays taxes on its profits, and then you pay personal income tax on the dividends you receive.
Typically, a C-Corp isn't the best structure for small business owners.
Salary vs. Owner's Draw
There are two primary methods of paying yourself as a business owner: salary and owner's draw. But it's also important to understand what dividends are and the role they can play in your payroll process.
Salary
A salary is a fixed, regular payment for services you provide to your business. It's most common in S-Corporations and C-Corporations but some LLC owners also pay themselves a salary.
As with everything in life, there are pros and cons to paying yourself a salary as an entrepreneur.
Pros
Predictable income: You know how much you'll be paid and when.
Easier budgeting: Regular paychecks help you organize your personal expenses better.
Building credit: Consistent salary payments can help when applying for loans or mortgages.
Retirement contributions: Salaries make it easier to contribute to retirement accounts like 401(k)s.
Tax withholding: Taxes are automatically withheld, which makes tax season easier.
Cons
Less flexibility: You're committed to a set amount, even if business slows down, which can be stressful.
Owner's Draw
An owner's draw is when you take money out of your business profits for personal use. Sole proprietors, partnerships, and some LLCs typically use this method.
Pros
Flexibility: You can adjust how much you draw based on how your business performs, business expenses, personal needs, etc.
Simplicity: You don't need to run payroll.
Cons
Tax planning: You'll need to set aside money for taxes, and it can be difficult to figure out how to do that.
Ultimately, how you get your compensation as a business owner depends on your business structure and personal preferences. Many business owners also use a combination of different methods.
Dividends
Dividends are distributions of company profits to shareholders. For small business owners, especially if you're running an S-Corp, dividends can be another way to receive income from your business.
For S-Corps, dividends (typically called distributions) aren't subject to payroll taxes. This makes them a great way to save on taxes after you've paid yourself a reasonable salary.
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Combination Methods
Some business owners combine different methods of paying themselves. For example, an S-Corp owner can pay themselves a reasonable salary and then take additional distributions as they need them.
Consult with a tax professional to learn more about your options for your particular business structure.
Paying Yourself as a Business Owner: Tax Implications
When you understand how taxes work, you can make more informed - and profitable - decisions about how to pay yourself as a business owner.
Salary
When you pay yourself a salary:
You'll pay income tax on your earnings.
You'll pay payroll taxes (Social Security and Medicare).
Your business can typically deduct your salary as a business expense to reduce your taxable income.
Owner's Draw
With owner's draws:
You'll pay income tax on your total business profit, not just what you withdraw.
You'll also pay self-employment taxes on your profit.
Draws aren't considered a business expense and don't reduce your business's taxable income.
Dividends
The tax treatment of dividends depends on your business structure:
In an S-Corporation, you typically don't have to pay payroll taxes on distributions (but they're still subject to income tax).
In a C-Corporation, you have to pay corporate tax on the dividends and then personal income tax when they're distributed to you ("double taxation").
How to Pay Yourself as a Small Business Owner to Optimize for Taxes
The best way to figure out how to pay yourself as a small business owner is to get professional advice from a tax professional.
That said, for S-Corps, the best strategy is typically to pay yourself a reasonable salary and take additional profits as distributions to potentially reduce payroll taxes.
Sole proprietors and partnerships usually use an owner's draw.
For LLCs, it depends how you elect for your business to be taxed (as a sole proprietorship or an S-Corp).
Common Mistakes (and How to Avoid Them)
As a tax professional, I see business owners make these business finances mistakes all the time:
Underpaying yourself: Reinvesting in your business is important, but consistently underpaying yourself can lead to stress in your personal life (and raise red flags with the IRS, especially if you're running an S-Corp).
Overpaying yourself: Taking too much out of your business can stunt its growth and create cash flow problems.
Mixing personal and business finances: This is a big no-no. Always keep your personal and business accounts separate to avoid accounting nightmares (and potential legal issues).
No tax planning: Not setting aside money for taxes or not understanding your tax obligations can lead to nasty surprises when paying off your tax bill.
Not adjusting how much you pay yourself as your business grows: As your business evolves, so should your compensation strategy.
To avoid these common mistakes, learn more about important tax considerations, and start paying yourself like a pro, work with a tax professional.
FAQs
How to Pay Yourself as a Business Owner (LLC)?
As an LLC owner, your options depend on how your LLC is taxed. If you're taxed as a sole proprietorship or partnership, you'll typically pay yourself through the owner's draws. If you've elected to be taxed as an S-Corporation, you'll need to pay yourself a reasonable salary and can then take additional distributions.
How to Pay Yourself as a Business Owner (S-Corp)?
In an S-Corporation, you're required to pay yourself a reasonable salary for the work you do in the business. This salary should be in line with what you'd pay someone else to do your job. After paying yourself a salary, you can take additional profits as distributions, which aren't subject to payroll taxes. You can't underpay yourself to save on taxes - the IRS closely monitors this.
How Much to Pay Yourself as a Business Owner?
The short answer is that it depends. You need to look at the financial health of your business, your personal financial needs, and possible tax implications of your decision.
A good rule of thumb is to pay yourself enough to cover your living expenses and a bit extra for savings. At the same time, you should leave enough of your business earnings to cover expenses and invest in things that help you grow, such as hiring service providers or a coach. As your business becomes more stable and profitable, you can increase your compensation.
Can You Write Off Paying Yourself as a Business Owner?
Whether you can write off paying yourself depends on your business structure and your process of paying yourself. If you're paying yourself a salary (common in S-Corps and C-Corps), this is generally deductible as a business expense. Owner's draws aren't deductible because they're considered a distribution of profits, not a business expense. Dividends aren't deductible either.
Stop Worrying About Your Taxes
Figuring out how to pay yourself as a business owner can be confusing, but you can create an effective system with the right education on the topic.
It's important to know that there are two main ways of paying yourself: salary and owner's draw. Sole proprietors, partnerships, and LLCs typically use the owner's draw system.
S-Corps and C-Corp owners must pay themselves a salary, but can also take additional income out in dividends. For S-Corp owners, doing this can lower your tax burden.
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