How to Pay Yourself as a Small Business Owner

Your small business needs money in the bank to pay the bills and meet your goals for the future. And, as the owner, you want to bring home a good income, or at least enough to feed yourself and keep a roof over your head. Paying yourself can sometimes seem like a tug of war between your needs and the needs of the business.

To strike the right balance, it's important to look at the numbers, decide how much money your business needs, and understand the way your income will be taxed. How your business is structured will also play a large role in determining how to pay yourself as a business owner. Here's an overview to help you get started.

 

Ways to pay yourself: Salary vs. owner’s draw

Business owners can pay themselves through a draw, a salary, or a combination method:

• A draw is a direct payment from the business to yourself.
• A salary goes through the payroll process and taxes are withheld.
• A combination method means you take part of your income as salary and part of it as a draw or distribution.

The method you use will depend on your business structure and tax situation.

Salary

A salary is a fixed payment received at regular intervals. Certain business structures, like S corporations, C corporations, or LLCs taxed as corporations, are required to use a salary for owner compensation instead of an owner’s draw.

• Pros: A salary is generally a more stable form of compensation, allowing for better predictability for both your business and personal finances. By opting for a salary over an owner’s draw, there won’t be any surprises when payday comes. Taxes are also withheld from your salary automatically, making it easier to pay income tax at the end of the year. Depending on your business structure, your salary may also be considered tax deductible for your business.
• Cons: While this form of compensation may provide increased financial consistency, a salary can create pressure to maintain the necessary cash flow to support it. Whether the company performs better or worse than anticipated, salary payments must be made consistently.

Owner’s draw

Using an owner’s draw as compensation means the owner is able to withdraw funds and other resources from the business at a time that benefits them and in whatever amount is necessary.

This type of compensation is typically used by businesses which operate as sole proprietorships, partnerships, and LLCs which are not taxed as corporations. In some business structures, an owner’s draw is used because government regulations specifically prohibit an owner from taking a salary.

• Pros: The biggest benefit of an owner’s draw system is flexibility. Business owners can tailor the timing and amount of their compensation to reflect their own needs as well as the performance of the company. This can take some of the pressure to produce cash flow off the company at times when business is slow or other expenses rise unexpectedly.
• Cons: Because taxes are not automatically withheld from an owner’s draw in the way they are under a salary-based system, your tax bill can be more difficult to navigate. Budgeting can be complicated because of inconsistent payments. Using an owner’s draw will also reduce the business’ equity, as assets are being removed from the company with each draw. Depending on the size and frequency of owner’s draws, this could affect the business’ ability to secure equity financing and its overall appearance of financial stability.

How to choose between salary or draw

To determine the best compensation structure for your business, you’ll need to look at three important factors: business structure, business performance, and your business’ ability to provide reasonable compensation.

Consider your business structure

If you are a sole proprietor or in a general partnership, you are not an employee of the business, you are the business. This means you will pay yourself a draw, and you will pay estimated taxes quarterly, including estimated state and federal income taxes and your self-employment taxes, which cover Social Security and Medicare.

If your business is a corporation and you work in the business, you are an employee of the business and you should pay yourself a salary, with taxes withheld. You do not have to take all your compensation as salary—you also can take a draw or distribution.

In an S corporation, all business profits flow through to the personal tax returns of the owners. An owner's salary is subject to payroll taxes, but distributions of profits are not. Some S corporation owners see a tax savings by limiting their salary and taking the rest of their pay as a distribution. However, the IRS requires the salary to be reasonable for someone in your position with your level of experience.

It can be hard to figure out how a salary or draw will affect your business or personal taxes. It will help to get advice from a tax professional.

Evaluate business performance

If your business performance is stable and you have a good idea of what your cash flow will look like from month to month and the structure of your business allows it, it might make more sense to choose a salary-based compensation structure. Maintaining consistent revenue and knowing how much money is flowing out of the business through payroll can make it easier to focus on the actual operations of your small business.

If cash flow is less consistent, or if you anticipate major fluctuations in the future, an owner’s draw system might make more sense for your business. When money is tight, you can adjust your compensation to reflect that. If business picks up appreciably, you can increase your compensation at your discretion. The flexibility of using owner’s draw can help you navigate whatever ups and downs your business might experience throughout the year.

Provide reasonable compensation

Certain business structures, especially S corporations, require business owners to limit their salary or draw to what the IRS considers to be “reasonable compensation.” The IRS defines reasonable compensation as “the amount that would ordinarily be paid for like services by like organizations in like circumstances.”

In cases where a business owner’s compensation is not in line with the compensation received by comparable positions at similar companies, there may be additional tax liabilities associated with the owner’s payment.

How much to pay yourself: Finding the magic number

Start by looking at the numbers: How much revenue is coming in, how much is going out in expenses, and how much cash do you have? Don't just look at this month's data—go back and see how your business has done over time. Project the amount of revenue and expenses you expect in the months to come. Don't forget to include:

• Taxes. Consider all that may apply to you: not only your personal and business income taxes but also payroll taxes and unemployment taxes.
• Occasional or annual expenses. Even though they occur less frequently, it's important to include expenses like insurance premiums and equipment repairs.
• Expansion plans. If you plan to move to a larger location, launch a more complex website, or expand your product line, you may want to accumulate cash in the business for that purpose.
• Expected fluctuations. An ice cream stand is going to do better in the summer than in the winter, and a service business may receive a big lump sum at the start of a major contract and then nothing for months.
• Your personal needs. Everyone’s lifestyle is different, and that will play a role in how much compensation you’ll need. Things like mortgage payments, children, and long-term growth of your personal and business accounts should all factor into your considerations about what to pay yourself. 

Use this information to figure out how much money the business needs in its accounts to stay afloat, with a comfortable cushion, in case your projections don't prove to be true. This will tell you what's available to pay the owners.

IRS guidelines

The IRS offers specific criteria for reasonable compensation in certain business structures. S corporations are the most strictly regulated in this way, but it’s a good idea to check if there are regulations that might impact your compensation based on your business’ structure.

The IRS uses a two-pronged test to determine if compensation is reasonable: an amount test and a purpose test.

The amount test examines how reasonable the payment amount is, and the purpose test looks at the services which warrant the payment. Both of these factors must be aligned with similar companies’ compensation plans for the IRS to consider the compensation reasonable.

In addition to these considerations, the IRS will look at a number of related elements of a business’ overall compensation plan to help determine if compensation is reasonable. These elements include:

• The company’s process for setting compensation
• Tax return information
• Number of employees
• Salary survey comparisons
• Other company’s sales, taxable income, and subordinate compensation plans

The process of getting paid

You'll need to decide how often to pay yourself. Biweekly is a common choice, but you also can pay yourself more or less often. At a minimum, pay yourself quarterly to stay on top of your tax obligations.

For owner’s draws

For a draw, you can just write yourself a check or electronically transfer funds from your business account to your personal one. 

Staying on top of your personal and business finances is particularly important when using this model, as you’ll want to keep track of your business equity before and after paying yourself to ensure you remain aligned with your financial plans. 

Because taxes aren’t automatically withheld from an owner’s draw, it’s important to set aside money for future tax payments whenever you draw money from your business.

For salaries

A salary is more complicated because you have to withhold payroll and income taxes. You can handle payroll processing yourself, but many business owners use a payroll service that calculates taxes, sends payments to taxing authorities, and generates pay stubs and W-2 forms.

Once you start paying yourself, stick to a consistent schedule. Reevaluate things throughout the year—and make changes if needed—to make sure you are meeting your business goals and obligations, as well as your personal ones.

FAQS

How much should I pay myself as a business owner?

No two businesses are the same, and no two business owners pay themselves exactly alike. Your compensation should be based on a combination of tax considerations, anticipated expenses, future business projections, and personal expenses to support your lifestyle.

What mistakes should I avoid when paying myself as a business owner?

Common pitfalls are different depending on whether you plan to pay yourself a salary or rely on an owner’s draw for compensation, but some of the most common mistakes include:

• Not setting aside money for taxes when using an owner’s draw
• Failing to ensure your salary falls within the IRS’ definition of reasonable compensation
• Underestimating or overestimating future cash flow and business expenses
• Choosing the wrong business structure to be able to compensate yourself in a way that suits your needs and lifestyle

Can I take a salary and an owner’s draw at the same time?

There are some situations in which a business owner can receive a salary and still be able to draw from yearly profits, but it’s largely dependent on the structure of the business. In most cases, the type of business you own will dictate whether you receive a salary, owner’s draw, or both.

What happens if I don’t pay myself as a business owner at all?

In many cases, you can elect to leave money in your business rather than taking a draw or a salary. This might be preferable in cases where your business is just starting, or in cases where it isn’t your primary source of income.

If your business is structured in a way where you must pay yourself a salary rather than a draw, however, you may find that this approach does not meet the standard for reasonable compensation. If your revenue is exceptionally low this could be an option, but in certain cases the IRS may interpret it as an attempt to avoid paying self-employment tax, which could prove costly and time-consuming in the long run.

 

Jane Haskins, Esq. contributed to this article.