How to Pay Yourself as a Small Business Owner: Salary vs. Owner’s Draw and Tax Implications
As a small business owner, one of the most important decisions you’ll face is how to pay yourself. Should you take a salary or an owner’s draw? Should you treat your compensation like an employee or is there more flexibility with how you pay yourself as the business owner? These decisions affect your income, taxes, and even the long-term growth of your business. Navigating these choices can feel overwhelming, but don’t worry – we’re here to break it down for you.
In this guide, we’ll walk through the two main ways small business owners pay themselves – salaries and owner’s draws. We’ll explain the differences, help you calculate a reasonable salary, and highlight the tax implications for LLCs, S-Corps, and other business structures. By the end, you’ll have the tools you need to make an informed decision and optimize your pay strategy for both you and your business.
1. Salary vs. Owner’s Draw: What’s the Difference?
When you’re running a small business, paying yourself isn’t the same as getting a paycheck from an employer. As the business owner, you have flexibility in choosing how you get paid, but this flexibility comes with important legal and tax considerations.
Salary: Taking a salary means paying yourself a regular, fixed amount, just like an employee. You’ll set up a payroll system and issue yourself paychecks on a regular basis (weekly, bi-weekly, monthly, etc.). This salary is considered a business expense and is subject to withholding for income taxes, Social Security, and Medicare.
Owner’s Draw: An owner’s draw is a withdrawal of funds from the business for personal use. It’s not a formal salary or wage. Instead, it’s a more flexible way for business owners to take money out of the company as needed. Owner’s draws are typically only used by sole proprietors, LLCs, and partnerships.
So, which is better for you?
The choice between salary and an owner’s draw depends on your business structure, cash flow, and long-term goals. Let’s break down the considerations for each.
2. How to Pay Yourself as an LLC Owner
If your business is structured as an LLC (Limited Liability Company), you have more flexibility in how you pay yourself. LLCs are considered pass-through entities for tax purposes, meaning that profits or losses flow through to your personal tax return.
Single-Member LLC: As the sole owner, you are considered a “disregarded entity,” meaning the IRS treats you and your business as one. You don’t technically take a salary, but instead, you make an owner’s draw. The money you withdraw is not subject to withholding, but it is still considered income on your personal tax return. Just remember, you’re responsible for paying self-employment taxes (Social Security and Medicare) on your earnings.
Multi-Member LLC: If you have partners in your LLC, you’re still paying yourself through an owner’s draw, but now there are two key distinctions: you’ll need to distribute profits according to the ownership percentages outlined in your operating agreement, and you’ll also need to file an informational return (Form 1065) to report LLC income.
3. How to Pay Yourself as an S-Corp Owner
If you’ve elected S-Corp status for your LLC or have formed a dedicated S-Corp, the rules change somewhat. Unlike LLCs, S-Corps require owners (also called shareholders) to pay themselves a reasonable salary for the work they perform in the business. This salary is subject to payroll taxes, including Social Security and Medicare.
Reasonable Salary: The IRS requires that you pay yourself a “reasonable salary” for the work you perform. What qualifies as reasonable is based on industry standards and the duties you perform within the business. If you’re unsure, it’s a good idea to check with a tax professional or use industry benchmarks.
Owner’s Draw in an S-Corp: After paying yourself a reasonable salary, you can take additional distributions or owner’s draws. These distributions are not subject to payroll taxes (though they are still taxable as income on your personal return). This tax advantage is one of the reasons why many small business owners choose the S-Corp structure.
4. How to Calculate a Reasonable Salary
If you choose to pay yourself a salary as an S-Corp owner, the IRS expects you to pay yourself a “reasonable” salary. But how do you figure out what’s reasonable? Here are some factors to consider:
Industry Standards: Research what other business owners in similar industries and geographic areas pay themselves for similar work. Industry surveys, job boards, and salary reports can give you an idea.
Time and Effort: How much time do you spend working in your business? The more time you spend managing operations or performing services, the higher your salary should be.
Profits and Financial Position: The salary should be aligned with your business’s profitability. If the business is just starting or is not yet generating a stable income, you may not be able to pay yourself a market-rate salary immediately. On the other hand, a highly profitable business should pay you a salary that reflects its success.
A reasonable salary should be high enough to avoid IRS penalties for underpayment (because the IRS wants you to pay your fair share of Social Security and Medicare taxes), but not so high that it depletes the company’s funds or leaves you overpaying in payroll taxes.
5. The Tax Implications of Paying Yourself
Paying yourself comes with tax implications that vary depending on whether you choose a salary or an owner’s draw. Here’s a breakdown of how taxes work for each option:
Salary: If you choose to take a salary, you’ll need to withhold federal income taxes, state income taxes (if applicable), Social Security, and Medicare from your paycheck. The business must also contribute its share of payroll taxes (employer’s portion of Social Security and Medicare) and file quarterly payroll tax returns (Form 941).
Owner’s Draw: If you take an owner’s draw, you’re not required to withhold any taxes at the time of withdrawal. However, you’ll still need to pay self-employment taxes (Social Security and Medicare) on your income when you file your personal tax return. It’s important to set aside money for taxes throughout the year, since you won’t have automatic withholdings like a traditional employee.
S-Corp Distributions: Distributions (or draws) from an S-Corp are not subject to payroll taxes, which is one of the key advantages of this structure. However, they are still subject to income tax. You’ll need to ensure you’re paying yourself a reasonable salary to avoid IRS scrutiny, and then you can take additional profits as distributions without paying payroll taxes on that portion of your income.
6. Key Considerations When Paying Yourself
Before deciding whether to take a salary or an owner’s draw, consider the following factors:
Business Cash Flow: Does your business have consistent, stable cash flow? If not, paying yourself a salary may be difficult. Owner’s draws offer more flexibility, but they don’t provide the same level of predictability.
Taxes and Deductions: How will your compensation affect your business and personal tax situation? Salaries provide a more predictable tax outcome, while owner’s draws may require additional planning to ensure you're saving enough for self-employment taxes.
Retirement Contributions: If you pay yourself a salary, you may be able to contribute to retirement plans like a 401(k), which can be a valuable tax advantage. Draws don’t have this benefit.
A Closing Thought
Deciding how to pay yourself as a small business owner is a critical decision that affects both your personal finances and your business’s tax strategy. Whether you opt for a salary or an owner’s draw, it’s essential to consider your business structure, cash flow, and long-term goals. By understanding the tax implications and calculating a reasonable salary, you can make an informed decision that aligns with your business’s financial health.
For more personalized advice, schedule a free Discovery Call. We can help ensure that you’re in compliance with tax laws and help you craft a compensation strategy that minimizes taxes and maximizes growth potential.
