You did it. You took the leap, started your business, and after pouring in countless hours of sweat and effort, you’ve started making money. Now comes one of the most exciting—and confusing—questions an entrepreneur can ask: “How do I pay myself?”
Taking money out of your business isn’t as simple as pocketing cash from the register. The method you use has significant legal and tax implications that are directly tied to your business’s legal structure. Getting it wrong can lead to overpaying on taxes or even running into trouble with the IRS.
Let’s break down the right way to pay yourself based on how your business is set up.
For Sole Proprietors and Single-Member LLCs: The Owner’s Draw
If you operate as a sole proprietorship or a single-member LLC (that hasn’t elected to be taxed as a corporation), the process is wonderfully simple. You are not an employee of your business. Therefore, you don’t run payroll or receive a W-2 salary.
- How it Works: You pay yourself through what’s called an owner’s draw. This is as straightforward as it sounds: you simply withdraw money from your business bank account and transfer it to your personal bank account. You can do this as needed, without a set schedule.
- The Tax Implications: This is the crucial part. You are not taxed on the amount you draw. Instead, you are taxed on the entire net profit of the business for the year, regardless of how much money you actually took out. The draw itself is just moving money from one pocket to another; it’s not a taxable event. All of that profit is subject to both regular income tax and self-employment taxes (for Social Security and Medicare). Because taxes aren’t withheld automatically, you are responsible for making quarterly estimated tax payments to the IRS throughout the year.
For Partnerships and Multi-Member LLCs: Draws and Guaranteed Payments
When a business has multiple owners, things get a bit more structured. There are typically two ways partners are compensated.
- Partner’s Draw (or Distribution): Similar to a sole proprietor, this is a withdrawal of profits from the business. The amount and frequency are usually outlined in the company’s partnership agreement. Just like with a sole prop, partners are taxed on their respective share of the total business profit, not on the amount they draw.
- Guaranteed Payments: These are payments made to a partner for services they provide to the business, which are paid out regardless of whether the business is profitable. Think of it as a salary-like payment for the work performed. These payments are considered a business expense for the partnership and are subject to self-employment taxes for the partner receiving them.
For S Corporations: The Salary and Distribution Strategy
This is where the rules change completely. If your business is an LLC that has elected to be taxed as an S Corporation, or you are structured as an S Corp, the owner who works in the business is considered an employee.
This legal distinction creates a two-part compensation structure:
- A Reasonable Salary: You must pay yourself a formal W-2 salary for the work you perform. This means running payroll, withholding federal and state taxes, and paying FICA taxes (Social Security and Medicare). The business pays the employer’s share of FICA, and you pay the employee’s share, just like any other employee. This salary must be “reasonable”—meaning it’s comparable to what someone in a similar role in your industry would earn.
- Distributions: Any remaining business profits after paying salaries and other expenses can be taken out as a distribution.
- The Tax Benefit: Here’s the key advantage of an S Corp. Your W-2 salary is subject to FICA taxes. However, the distributions you take are not subject to FICA or self-employment taxes. This can lead to significant tax savings on every dollar you take as a distribution versus a salary, which is the primary reason business owners elect S Corp status. Be warned: The IRS scrutinizes this closely. You cannot pay yourself an artificially low salary (e.g.,
10,000)and take a huge distribution(150,000) just to avoid taxes.
For C Corporations: Salary and Dividends
Like an S Corp, owners of C Corporations who work in the business are employees and must be paid a reasonable W-2 salary.
Where they differ is how profits are distributed. After the corporation pays its expenses and salaries, it pays corporate income tax on its net profit. If the remaining profit is then distributed to shareholders (the owners), it’s done so as a dividend. The owner then pays personal income tax on that dividend. This creates what’s known as “double taxation” (the profit is taxed once at the corporate level and again at the personal level), making it a less common choice for small businesses.
Choosing how and when to pay yourself is a major financial decision that goes beyond just accessing your hard-earned money. It affects your tax burden, your compliance, and your ability to plan for the future.
At Kohani & Associates, we specialize in helping business owners navigate these exact questions. We can help you analyze your profitability to determine the most tax-efficient compensation strategy for your specific business structure. Whether it’s advising on a reasonable salary for your S Corp or setting up a plan for your quarterly estimated taxes, we provide the clarity you need to pay yourself with confidence.
If you’re ready to create a smart, sustainable compensation strategy, contact us for a consultation.