One of the most common questions small business owners ask is, “How should I pay myself?”
The answer is not as simple as transferring money from your business checking account to your personal checking account.
How you pay yourself depends heavily on how your business is structured for tax purposes. A sole proprietor, single-member LLC, partnership, multi-member LLC, S corporation, and C corporation can all have very different rules when it comes to owner compensation.
Understanding the difference between an owner’s draw and a salary can help you avoid unnecessary payroll taxes, prevent tax problems, maintain clean bookkeeping, and make better decisions about your business structure.
At Knobbe and Associates, CPA, we help small business owners understand not only how to pay themselves, but why they should be paying themselves that way.
Let’s break it down.
What Is an Owner’s Draw?
An owner’s draw is money an owner takes out of a business for personal use.
For example, suppose your business earns $100,000 during the year and you transfer $5,000 from your business bank account to your personal bank account. That transfer may be recorded as an owner’s draw depending on your entity and tax classification.
An owner’s draw is not the same thing as a business expense.
If you own a business and take $5,000 for yourself, you generally cannot deduct that $5,000 as a business expense simply because it left the business bank account.
This is where many new business owners get confused.
Your business’s revenue, expenses, profit, and owner withdrawals are separate concepts.
You can have:
$100,000 of revenue
$60,000 of business expenses
$40,000 of business profit
$25,000 of owner withdrawals
The $25,000 you withdrew does not automatically determine your taxable income.
Depending on the type of entity, you may owe tax on the business’s $40,000 of profit even if you only withdrew $25,000.
How you pay yourself should therefore be based on your business structure and tax classification, not simply on how much cash you need personally.
How Do Sole Proprietors Pay Themselves?
A sole proprietorship is generally the simplest business structure for owner compensation.
A sole proprietor does not technically pay themselves a salary.
Instead, the owner takes an owner’s draw.
For example:
Business revenue: $100,000
Business expenses: $60,000
Net business profit: $40,000
Owner’s draws: $30,000
The owner generally reports the $40,000 of business profit on Schedule C rather than reporting the $30,000 draw as wages.
The IRS considers a sole proprietor to be self-employed. Net earnings from the business are generally subject to self-employment tax in addition to federal income tax.
This means you should not set yourself up as an employee of your sole proprietorship simply because you want a regular paycheck.
Instead, you can transfer money from the business to yourself as an owner’s draw.
One important distinction: an owner’s draw is not a tax-free way to avoid paying taxes. The tax is generally based on the business’s taxable profit, not the amount you decide to withdraw.
How Do Single-Member LLC Owners Pay Themselves?
This is where things get confusing.
An LLC is a legal entity created under state law, but the IRS determines how that LLC is taxed.
A single-member LLC that has not elected to be taxed as a corporation is generally treated as a disregarded entity for federal income tax purposes.
In other words, for federal income tax purposes, the IRS generally treats the business activity as belonging directly to the owner.
For an individual owner, that generally means the business activity is reported on Schedule C of the owner’s Form 1040.
So how does the owner get paid?
Generally, through owner’s draws rather than payroll.
The owner does not issue themselves a W-2 from the single-member LLC simply because the LLC has an EIN or because the LLC is registered with the state.
The IRS specifically states that an individual owner of a single-member LLC classified as a disregarded entity is generally not an employee of the LLC and is instead subject to self-employment tax on the LLC’s net earnings in the same manner as a sole proprietor.
This is an important concept:
The LLC may provide legal liability protection under state law, but that does not automatically mean the owner is an employee for federal tax purposes.
If you own a single-member LLC that is taxed as a disregarded entity, your business profit is generally attributable directly to you.
That is particularly important for service-based businesses.
If you are the person performing the work that generates the revenue — whether you are a consultant, contractor, therapist, photographer, realtor, accountant, coach, or another service provider — the IRS generally does not treat your business profit as though an unrelated employee generated it for you.
You are the self-employed owner generating the income.
That is why simply moving money between your business and personal bank accounts does not turn that money into a deductible salary expense.
Can an LLC Owner Elect S Corporation Tax Treatment?
Yes.
This is one of the biggest decisions an LLC owner may eventually consider.
An LLC can elect to be taxed as an S corporation if it meets the requirements.
When an LLC makes an S corporation election, the tax treatment changes significantly.
Instead of simply taking owner’s draws as a sole proprietor, the owner who performs services for the S corporation generally becomes a shareholder-employee.
That means the business generally needs to pay the owner reasonable compensation through payroll.
This is where salary vs. distributions becomes extremely important.
S Corporation Salary vs. Distributions
S corporation owners generally have two primary ways of receiving money from the business:
Wages through payroll
Shareholder distributions
These are not interchangeable.
If you are an S corporation shareholder who performs meaningful services for the business, the IRS expects you to receive reasonable compensation for those services before taking non-wage distributions.
For example, imagine an S corporation produces $150,000 of profit before owner compensation.
The owner works 40 hours per week, performs essentially all of the services that generate the company’s revenue, manages clients, handles sales, and runs the business.
The owner cannot simply decide:
“I’m going to pay myself a $20,000 salary and take the remaining $130,000 as distributions.”
The IRS looks at the services the shareholder actually performs and the source of the company’s gross receipts when evaluating reasonable compensation.
The IRS specifically identifies three major sources of S corporation gross receipts:
Services performed by the shareholder
Services performed by non-shareholder employees
Capital and equipment
If the shareholder personally generates the company’s revenue through their own services, that is a major factor in determining reasonable compensation.
Factors that can be considered include the owner’s training and experience, duties and responsibilities, time devoted to the business, compensation paid to other employees, comparable compensation for similar work, and the way compensation is structured.
After paying reasonable compensation, additional money may generally be distributed to the shareholder.
Those distributions are generally not subject to Social Security and Medicare taxes in the same way wages are, although other tax rules — including stock basis limitations — must be considered.
This is one of the primary reasons an S corporation can potentially provide tax savings for certain profitable business owners.
But there is no magic “pay yourself 40% as salary” rule.
Reasonable compensation needs to be determined based on the actual facts of the business.
How Do Partnership Owners Pay Themselves?
Partnerships work differently.
Partners are generally not employees of the partnership and should not receive a W-2 for their partnership compensation.
Instead, partners can generally receive:
Distributions
Guaranteed payments
Their distributive share of partnership income
A guaranteed payment is often the closest thing to a “salary” for a partner.
For example, suppose two partners own a business 50/50.
Partner A handles operations and works full-time.
Partner B is primarily an investor and works very little in the business.
The partnership agreement could potentially provide Partner A with a guaranteed payment for services before the remaining partnership income is divided according to the partners’ ownership percentages.
Guaranteed payments are generally determined without regard to partnership income and can compensate a partner for services or the use of capital.
The partnership generally reports guaranteed payments on Form 1065 and the partner receives the appropriate information on Schedule K-1.
Importantly, a guaranteed payment is not the same thing as an employee salary.
Partners are generally self-employed rather than employees of the partnership.
Multi-Member LLCs and Owner Compensation
A multi-member LLC is generally treated as a partnership for federal income tax purposes unless it elects corporate taxation.
Therefore, if your LLC has two or more members and is taxed as a partnership, the owners generally should not be put on payroll simply because they work in the business.
Instead, compensation may involve guaranteed payments, distributions, and allocations of partnership income according to the operating agreement and applicable tax rules.
This is another situation where “owner’s draw vs. salary” can become misleading.
The business owner may receive regular payments, but that does not automatically make those payments wages.
The tax treatment depends on how the business is classified and what the payment represents.
What About a C Corporation?
C corporations are different from sole proprietorships, partnerships, and S corporations.
A C corporation is a separate taxpayer, and an owner who works for the corporation is generally an employee.
That means the corporation can pay the owner a salary through payroll.
The corporation generally deducts reasonable compensation as a business expense, while the employee reports wages on their individual tax return.
C corporation owners can also potentially receive dividends, although dividends have different tax consequences from wages.
Because C corporations can involve corporate-level taxation plus shareholder-level taxation on dividends, business owners should not choose a C corporation simply because they want to “pay themselves a salary.”
The entity choice should be based on the entire tax and business situation.
Owner’s Draw vs. Salary: Quick Comparison
Sole Proprietorship:
Usually owner’s draws. No W-2 salary to the owner. Business profit is generally reported on Schedule C and subject to applicable income and self-employment taxes.
Single-Member LLC, Disregarded Entity:
Generally owner’s draws. The owner is generally not an employee of the LLC for federal tax purposes. Business activity is generally reported directly on the owner’s tax return.
Multi-Member LLC Taxed as Partnership:
Generally no W-2 salary for members. Owners may receive distributions and guaranteed payments, depending on the circumstances and operating agreement.
Partnership:
Partners are generally self-employed, not employees. Guaranteed payments can function somewhat like compensation for services, while partners also receive their distributive share of partnership income.
S Corporation:
Shareholder-employees who perform services generally need reasonable compensation through payroll. Additional distributions may be possible after appropriate compensation is paid.
C Corporation:
Working owners are generally employees and can receive wages through payroll. Dividends are separate from salary.
So, Which Way Should You Pay Yourself?
The biggest mistake business owners make is deciding how to pay themselves before deciding how their business should be taxed.
Your payment method should follow your entity structure and tax classification.
If you are a sole proprietor or single-member LLC taxed as a disregarded entity, you generally do not need to create payroll for yourself simply to pay yourself. Owner’s draws are generally the appropriate method of moving money from the business to you personally.
If you are operating as an S corporation, you need to take reasonable compensation seriously. Underpaying yourself while taking large distributions can create unnecessary IRS exposure.
If you operate a partnership or multi-member LLC taxed as a partnership, you should understand the difference between guaranteed payments, distributions, and your distributive share of partnership income.
And if you are considering changing your tax classification, do not make the election simply because someone told you that “S corps save taxes.”
An S corporation can be valuable, but it also creates additional administrative requirements, payroll obligations, tax filings, and reasonable compensation considerations.
The right question is not:
“How can I pay myself the least amount of salary?”
The better question is:
“What compensation structure makes sense for my business, my work, my profitability, and my tax situation?”
Your Business Structure Determines How You Get Paid
Owner’s draw vs. salary is ultimately a tax classification question.
A $5,000 transfer from a business checking account does not have the same tax treatment for every business owner.
For one business owner, it may be an owner’s draw.
For another, it may be a shareholder distribution.
For another, it may be a guaranteed payment.
For another, it may be payroll wages.
And treating the payment incorrectly can create tax, payroll, and bookkeeping problems.
If your business is growing, this becomes even more important.
The way you paid yourself when your business made $30,000 may not be the best strategy when it makes $150,000. Likewise, an S corporation election that makes sense for one business may not make sense for another.
At Knobbe and Associates, CPA, we help small business owners evaluate their business structure, bookkeeping, tax planning, owner compensation, payroll, and overall tax strategy.
If you are asking, “How should I pay myself from my business?” or “Should my LLC elect S corporation status?” that is a conversation worth having before you make the change — not after tax season.
Your business should be structured around your goals, not around a tax strategy you found in a Facebook group.
Contact Knobbe and Associates, CPA to build a proactive tax and business strategy designed around your business.
