But how do those profits translate into official income? How you pay yourself as an entrepreneur can vary based on the type of small business you’ve created and how you’d like to handle the tax implications of your income.
As your business grows, your owner’s payment method can evolve as well. Additionally, you want to be sure that you set up your new business income correctly both now and later to avoid finding yourself on the wrong side of the IRS.
Two main ways to pay yourself: owner’s draw or salary
As a small business owner, you essentially have two choices of how to pay yourself.
Which method is the best option for you will depend on your business structure, how evolved your business is, the tax implications of each option, and the nature of your involvement with running the business.
One option for paying yourself is the owner’s draw method.
If you pay yourself this way, you’ll simply draw funds from your business profits when you need or want them. You have a lot of flexibility about when you take funds and how much, which can easily accommodate various cycles in business income.
The other method of paying yourself is the salary method. If you choose this method, you’ll set up your business accounting to pay yourself a regular salary just like any other employee.
Pros and cons of the owner’s draw method
The owner’s draw method offers a business owner a great deal of flexibility. It allows you to adjust your compensation based on how your business is doing.
The downside of the owner’s draw is the amount of paperwork that may be involved.
Since you’ll need to report profits as business income and pay self-employment taxes, you’ll need to keep the IRS in the loop through quarterly estimates and filings.
Owner’s draws are neither considered nor taxed as personal income. Instead, you’ll need to calculate the actual business profits. You will need to plan for and pay quarterly business taxes, which will vary along with your draw. This can add additional bookkeeping and accounting duties for a business owner.
Pros and cons of the salary method
The salary method gives you a steady, predictable income from your business. Once your salary is set up, state and federal income taxes are automatically deducted from your check, just as they would be at another place of employment.
You’ll also have a history of steady paychecks should you need that evidence for a mortgage or other line of credit.
Paying yourself a set amount every month also makes it much easier to track your business finances. There is also less fluctuation in paperwork and business capital.
The downside of the salary method is the research it can take to settle on the “right” salary. Your salary amount must satisfy the IRS’s “reasonable salary” rules.
According to the IRS, your salary should be comparable to what someone in a similar position in a similar company would be paid. Essentially your income should match (or come close to matching) standard industry pay. You do have the option to adjust your salary or pay yourself a bonus at the end of the year.
How to pay yourself as a sole proprietor, partnership, or LLC
If you are running a sole proprietorship, a partnership, a limited liability company, or LLC, you will likely want to use the owner’s draw method for paying yourself from your business. This means you simply transfer funds from your business bank account to your personal one when you need cash.
If you are a sole proprietor or a single-member LLC, you can take as much money from your company as you’d like, provided your business remains viable. There are no partners or shareholders to consider to accommodate your payment structure or decisions.
Also, if you are a single member or multi-member LLC, you will have to use the draw method since LLC members are not allowed to pay themselves a regular salary.
If you are a member of a partnership or a multi-member LLC, you will need to split revenue between partners. In a partnership, your income distribution between partners should be outlined in your partnership agreement. This might be a 50/50 split, 60/40, or even 70/30 depending on the structure of your business.
What’s most important is that you follow the plan in your partnership agreement and that the partnership file a Schedule K-1 with the IRS at the end of the year to show the owner’s draws along with the business profits, business expenses, losses, credits, and deductions.
At tax time, sole proprietors and partners will file income tax forms and pay taxes on the business profits rather than just the draws they made throughout the year. The same is true for LLCs. This will require these business owners to plan for and pay quarterly tax estimates to ensure they follow IRS rules and avoid a hefty tax bill.
How to pay yourself as the owner of an S corp
As the owner of an S corporation, you must take a salary from your business. You do also have the option to take non-taxable distributions from the company as well, but there are limits on those distributions and legal requirements for a set, documented salary as reasonable compensation.
As the owner of an S corp, you’ll want to choose a reasonable salary each year to satisfy the requirements of the IRS as well as your own income needs. Additionally, you’ll want to be sure that the salary you’re choosing isn’t going to cripple your business operations by removing too much cash.
The IRS is typically very interested in the salary that corporations pay their owners. The reasonable salary requirement states that business owners must be paid “an amount that would ordinarily be paid for like services by like organizations in like circumstances.” This means you’ll need to benchmark your salary using the salaries of other owners of companies like yours.
The reasonable salary you determine will be your primary means of being paid by your S corp. If you also take non-taxable shareholder distributions, remember that these are not an owner’s draw, and they cannot replace taking a salary. The IRS will catch it and you’ll be facing an audit situation.
How to pay yourself as the owner of a C corporation
As the owner of a C corporation, you’ll be tasked with meeting the same salary requirements as an S corporation. Your company must pay you a reasonable salary based on the type of organization in similar industries and services.
Additionally, C corporations can give owners a dividend distribution, much like an S corporation. However, unlike a dividend distribution from an S corp, dividends from a C corp are taxable for shareholders.
At tax time, owners of corporations will file their corporate tax returns as well ase their own personal tax returns. The salary paid through the corporation will be treated like any other W-2 salary.
Since payroll taxes were deducted from the regular paychecks, there is likely no need for additional personal tax payments at the end of the year. If you received dividend distributions from a C corporation, you would need to include those amounts on your personal income tax return and pay taxes accordingly, however.
Corporations will file taxes and make required tax payments separately as business entities. The IRS has clear guidelines for corporation owners about the best ways to pay themselves salaries and dividends.
How do you decide how much to pay yourself?
If you have opted for an owner’s draw, paying yourself doesn’t require a lot of upfront consideration. You simply take money out of your business profits when you need it, and the company has profits to spare. Be sure to account for tax payments and create a strong paper trail of your draws.
If you are opting to pay yourself a salary, however, you will need to meet the IRS’s definition of what is considered reasonable in addition to finding the sweet spot of income that pays your personal bills and doesn’t hurt your company’s profitability. There are a few things to consider when setting the right salary.
How much your company is making. If your company is new and has tight cash flow, a high salary or draw might be a death knell. Conversely, if your company is making a lot of money, you’ll want to consider the tax implications of those profits as a business or passed through as owner income.
How much money you need. Your income should cover your needs and your own personal expenses.
How much others in similar roles make. The IRS wants you to pay yourself about what others make in similar roles in similar circumstances. If other consultants in your industry are making $200,000 per year, the IRS will look hard at your owner’s salary of only $30,000.
Your location and cost of living. Are you in a high-cost part of the country? Is inflation a factor you need to consider?
How you want to live. If your business is doing well, profits are rolling in, and you’re feeling comfortable and confident with all aspects of your business needs, set your salary or owner draws at a level that reflects the lifestyle you’ve been working toward.
How Bench can help
You’ll want to begin with the end in mind, especially when it comes to tax planning and subsequent bookkeeping. If you’ve been unsure of how to best pay yourself as your business has been developing, you may have mistakes in your financial books that can lead to larger tax problems down the road.
We’re America’s largest bookkeeping service for small businesses, and we want to help! We can handle your bookkeeping and tax filing so that you can run your business confident that your books are clean, your financials are sound, and you’re in good standing with all the various intricacies of running a small business.
The bottom line
Being your own boss is one of the best parts of running your own business. Regardless of the type of business you’re running and how and what you choose to pay yourself, keep your business and personal finances clearly separated, budget for the necessary tax payments, and be consistent and clear with your payment plan.