There are two main ways to pay yourself as a business owner: a salary or an owner’s draw. Your business structure determines which options are available and how taxes work.
At a glance:
- Two main methods: salary or owner’s draw.
- Your business structure determines which options are available.
- Sole proprietors and partners generally take draws.
- S corp and C corp owners must pay themselves a reasonable salary.
- Taxes work differently depending on the method you choose.
Salary vs. owner’s draw
Salary method
You pay yourself through payroll on a regular schedule, like any other employee. Federal and state income taxes are withheld, along with Social Security and Medicare taxes (FICA). As the business owner, you also pay the employer portion of Social Security and Medicare taxes, and your company may owe federal and state unemployment taxes.
- Pro – stability: A recurring, stable salary expense helps with budgeting and long-term planning.
- Pro – automatic withholding: Taxes are withheld upfront.
- Con – less flexibility: S corp owners (and shareholder-employees of C corps) must follow the IRS “reasonable compensation” rule. Your salary must be comparable to what an employee in the same role and industry would earn.
Owner’s draw method
You withdraw funds from your company’s profits (not revenue) on an as-needed basis. The amount you can withdraw depends on your owner’s equity:
Assets (cash, inventory, equipment, etc.) − Liabilities (debts, bills, etc.) = Equity
With draws, taxes are not automatically withheld. Your business profits are still subject to income tax and, in most cases, self-employment tax (Social Security and Medicare). Many business owners must make quarterly estimated tax payments to avoid penalties.
Owner’s draws are not tax-deductible business expenses. Taking a draw does not reduce your taxable business income; it simply moves money from your business account to your personal account.
- Pro – flexibility: More control over how much you draw and when, based on business performance.
- Con – no automatic withholding: You must budget for your quarterly tax bill and keep detailed records.
How to pay yourself based on business type
- Salary method: S corps and C corps
- Owner’s draw method: Sole proprietorships, partnerships, LLCs
Note: Because taxes are not withheld automatically, many sole proprietors, partners, and single-member LLC owners must make quarterly estimated tax payments if they expect to owe $1,000 or more in taxes for the year.
C corps
You are legally obligated to pay yourself a salary as a W-2 employee with the appropriate taxes withheld. Any additional payment on top of salary must be treated as a dividend.
S corps
You must pay yourself a reasonable salary (subject to payroll taxes) and can also take distributions on top of that (not subject to payroll taxes). Your salary must be reasonable; you cannot skip payroll and take only distributions. The IRS can reclassify distributions as wages if your compensation is too low.
Sole proprietors
The draw method is your only option; you cannot legally pay yourself a salary. Your net profit (business income minus deductible business expenses) is reported on Schedule C and flows to your Form 1040. That net profit is subject to personal income tax and self-employment tax, regardless of how much you actually withdraw.
Partnerships
The IRS does not consider partners to be employees, so you take draws and are taxed like a sole proprietor. Another option is guaranteed payments, which are payments to partners for services or use of capital regardless of partnership profits. They are ordinary income to the receiving partner, generally subject to self-employment tax, and have no automatic withholding. They can be useful in early startup years when the partnership may not yet be profitable.
LLCs
By default, a single-owner LLC is treated as a sole proprietorship (a “disregarded entity”) for tax purposes. Multi-member LLCs are classified as partnerships but can elect to be taxed as an S corp. To be taxed as a corporation, you generally file Form 8832; to be taxed as an S corp, you typically file Form 2553.
How much should you pay yourself?
The answer differs for everyone. Consider:
- How is your business performing? Know your financial reports and cash flow. You need enough profit to pay yourself a reasonable salary in the eyes of the IRS.
- What are your growth expectations? A rapidly growing business may need cash on hand to reinvest, so you might pay yourself enough to cover basic expenses and put the rest toward growth.
- What personal expenses do you need to cover? Understand your family’s basic needs and what you can reasonably live on.
FAQs
Is it better to take a salary or an owner’s draw?
It depends on your business structure. Corporations generally must pay owners a salary if they actively work in the business. Sole proprietors and partners must take owner’s draws instead of wages. S corporations can use a combination of salary and distributions, as long as the salary meets the IRS reasonable compensation requirement.
Can I combine salary and distributions?
Only for certain business types. An S corp owner can pay themselves a reasonable salary and take additional distributions. For sole proprietors and partnerships, there is no salary/distribution split; everything is business profit.
Do I pay taxes when I take an owner’s draw?
You do not pay taxes on the draw itself. You pay taxes on your business’s net profit. If your business is profitable, you owe income tax and, in most cases, self-employment tax, even if you leave the money in the business.
Do I need to make quarterly estimated tax payments?
Many sole proprietors, partners, and S corp owners do. If you expect to owe $1,000 or more in taxes for the year, the IRS generally requires quarterly estimated tax payments to avoid penalties and interest.
What is reasonable compensation?
It applies to S corp owners and shareholder-employees of C corps. It means paying yourself a salary comparable to what someone else would earn performing the same services in a similar role, industry, and geographic area. The IRS evaluates factors such as duties, experience, and time devoted to the business.
Does paying myself reduce my business taxes?
Not necessarily. For corporations, salary paid to you as an employee is generally deductible to the business. Owner’s draws are not deductible. For sole proprietors and partners, business profits are taxable whether you withdraw the money or not.
What is the QBI deduction, and does it apply to me?
The qualified business income (QBI) deduction (Section 199A) allows eligible sole proprietors, partners, S corporation owners, and some LLC owners to deduct up to 20% of their qualified business income. Eligibility depends on your total taxable income and the type of business you operate (must be a pass-through entity).
Can I change how I pay myself later?
Possibly, but it may require a formal tax election (such as electing S corporation status), filing the appropriate IRS forms, and setting up payroll. Because changing your structure affects taxes, review your options carefully first.
This article is for informational purposes only and not legal or financial advice.