How to Pay Yourself as a Business Owner: Get the Best Return

As a business owner, earning an income is a little more complicated when you own your own business. Depending on the type of business you have, you have a couple of ways to get paid. It’s vital you choose the right option to ensure you’re complying with the right tax laws.

Key Points:

• Business owners can choose from a salary or owner’s draw when deciding how to pay themselves. Sole proprietors may like an owner’s draw best while larger corporations are required to take a salary. 
• Both choices have tax implications that the business owner needs to address. 
• You must pay yourself a reasonable salary, equivalent to others in a similar position.  

Step One: Determine Your Business Entity 

The first step to paying yourself is to determine the type of business entity you have. The type of entity you work as can have an impact on the amount of taxes you will owe and the type of payment you can give yourself. Here are the most common types of business entities:

• Sole Proprietorship.
• Partnership.
• Corporation.
• Limited Liability Company (LLC).

Sole Proprietorship

A sole proprietorship is a business that is owned and operated by one person. This is the simplest and most common type of business entity and all income is taxed as personal income, meaning you’ll have to pay estimated quarterly taxes throughout the year. 

Partnership

A partnership involves two or more persons who share ownership and profits. All partners in the business report their share of the profits and losses on their personal tax returns.

LLC

An LLC is a hybrid between a corporation and a partnership. It offers the limited liability of a corporation (more on that in one second) and the flexibility of a partnership. Profits and losses are passed through to the owners’ personal tax returns and taxed at their individual rates.

C Corporation

A C Corporation is a type of business entity that is separately recognized from its owners for the purpose of taxation. It is called a C Corporation because it is taxed according to Subchapter C of the Internal Revenue Code. These corporations are subject to double taxation, meaning that the income earned by the corporation is taxed at the corporate level, and the shareholders or investors are also taxed on the profits they receive from the corporation in the form of dividends. 

S Corporation 

An S corporation is a special type of corporation that has the same legal protection as a C corporation but is taxed differently. Instead of the corporation paying income tax, the profits, losses, deductions, and credits are passed through to the shareholders and reported on their individual income tax returns. This means that the income of an S corporation is only taxed once (at the individual level) instead of twice (at the corporate and individual levels) like with a C corporation. 

Step Two: Figure Out the Best Payment Method

When deciding how to pay yourself as a business owner, you’ll have two main options:

• Get paid via a salary.
• Do an owner’s draw.

Both of these methods are meant for different business types and have varying tax implications associated with them. 

What is a Salary?

When a business owner pays themselves a set salary, it’s similar to any other employee getting a salary. Taxes are withheld from the paycheck and you’re paid on a regular schedule. This payment option is legally required for businesses that are corporations or LLCs that are taxed similarly to corporations.

Now, don’t think just because you’re the owner or one of the owners in the business that you get to arbitrarily decide how much you make. The IRS has a “reasonable” compensation rule that states you can only make what someone in a similar position would make. 

What is an Owner’s Draw?

An owner’s draw is a method of taking money out of a business to pay yourself as a business owner. When an owner takes out a draw, the money is taken from the business’s capital account and deposited into the owner’s personal bank account. This money can then be used to fund personal expenses, such as a home mortgage, car payments, or other living expenses.

This type of payment is typically used by sole proprietors or individuals who own and operate their own businesses. The money taken out of the business as an owner’s draw is considered a form of income, and is subject to self-employment taxes, so business owners need to make sure they’re setting aside enough to cover these taxes. 30% of your income tends to be a good estimation.

By taking an owner’s draw, the business owner can still receive an income while keeping their business’s funds intact. It’s important to note that there are no tax deductions associated with an owner’s draw and all money taken out is considered personal income. 

Pros and Cons of Taking a Salary

Pros

• Stability. Taking a salary ensures consistent cash flow which is beneficial when planning budgeting and forecasting. 
• Potential tax benefits. Setting a standard salary can result in lower taxes, as certain deductions can be made.  
• Avoidance of risk. A salary gives you a steady income, rather than relying on sporadic profits, reducing the risk in a business.  

Cons

• Opportunity cost. Depending on the size of the salary you’re taking, this could reduce the amount of funds available to reinvest into your business.
• Can be difficult to know how much to take. Determining how much salary to pay yourself can be tricky since you must factor in the costs associated with taking a salary and pay yourself a fair wage for your work.

Pros and Cons of Owner’s Draws

Pros

• Allows the owner to have more control over their salary. Owner’s draws can be taken when the business makes a profit, so the amount of salary withdrawn can be tailored to how much effort the owner is putting into the business. 
• More flexibility. An owner’s draw is simply taking money, as needed, from your business. Freelancers often do this, where most of what they make through their business becomes their salary. This provides more flexibility than a set salary. 

Cons

• Tax implications. If an owner’s draw is taken, it will be taxed as income and the owner will be responsible for paying the self-employed tax on the amount taken out. 
• Can lead to cash-flow problems. If the owner takes out too much in owner’s draws, it can leave the business short on cash, which can lead to problems paying bills and other expenses. 

Choosing Between Salary and Owner’s Draw

When trying to decide whether to take a salary or an owner’s draw as a business owner, there are several factors you’ll want to consider, including:

• Business structure. Depending on the structure, taking a salary may be more beneficial for tax purposes. Certain business types are required to take a salary, while others get a choice. 
• Business growth. The stage of growth of the business is another important factor to consider. If the business is just starting out and is likely to be in the red for some time, taking a salary may not be feasible. In this case, an owner’s draw may be the best option.
• Business performance. If the business is doing well and there is enough income to cover the salary of the business owner, taking a salary may be the best choice. However, if the business is struggling and needs additional finance, an owner’s draw may be the better option.
• Personal finances of the owner. The business owner’s personal finances should be taken into account when making the choice of how to get paid. A salary will offer more security, but if the owner needs more money to cover personal expenses, an owner’s draw may be the better option.

Step Three: Decide How Much to Pay Yourself

When asking yourself ‘how much should I pay myself as a business owner’, you need to first have a clear understanding of your business’s financial health. Before you set a salary for yourself, consider the following factors:

• Revenue. Examine your business’s current and projected revenue and determine how much you can afford to pay yourself without putting the business in a difficult financial situation.
• Expenditures. Carefully review your business’s current monthly and annual expenses and consider how large of a salary you can pay yourself without cutting into other necessary business expenses. If you don’t have many expenses, an owner’s draw might make more sense. 
• Business goals. Set a salary or owner’s draw amount that helps you reach your business’s long-term objectives. For example, if you want to increase the number of employees you have, you’ll need the money to hire them.
• Availability of funds. Consider the funds you currently have available and the outside funding sources like startup loans. If you can use loans to help offset certain costs, you may be able to take a larger salary or draw. 
• Market rate. Research the market rate for someone with your skills and experience and use this information to inform your salary amount.
• Consider your household needs. You’ll need to balance out your business needs and your personal financial needs when deciding how much to pay yourself. You need enough to cover your bills, but you also want some money saved to put back into the business. 

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