So, you’ve decided to be your own boss—congratulations! Now comes the fun part: figuring out how to pay yourself.
When I launched my business in 2003, I faced the same dilemma. Even with my background in public accounting, transitioning from someone who received a paycheck to someone who had to figure out how to write one for myself was an entirely new experience.
I vividly remember wondering if I needed to be on my business’s payroll. I quickly figured it out, but I share this story because wondering about this is a normal question new business owners have. You are not alone. If you have been working for someone else your whole career, more than likely you have been receiving a paycheck, and now—well, you’re the one writing the paycheck. And yet, getting money out to yourself is still super important. After all, how could you put yourself through all of these other challenges of leading a business without making sure to put a little money in your own pockets?
When new clients come to us, especially those who are first-time business owners, the question of paying themselves is a common one.
And, of course, the answer isn’t simple. It depends on the type of entity your business is, because why would accounting, payroll, and tax matters ever be straightforward?
How to Pay Yourself as a Sole Proprietor
If you operate as a sole proprietor (also known as a sole prop, SCH C, or single-member LLC), think of it as having two pockets—your business money and your personal money.
When paying yourself, you essentially transfer funds from one pocket to the other. Unfortunately, you cannot deduct this money transfer as an expense.
All income generated before paying yourself is taxable, and this withdrawal is commonly referred to as an "owner's draw."
How to Pay Yourself as a Partner
As a partner in a business, compensating yourself works a bit differently than it does for sole proprietors or corporate owners.
Partnership Structures and Their Tax Filing Requirements
Partnerships can take the form of general partnerships, limited partnerships, or the commonly seen structure of an LLC taxed as a partnership.
Partnerships and LLCs file a separate tax return, and the profits or losses flow through to the partners via Schedule K-1. In this case, the partnership itself does not pay taxes, and each partner reports their share of income on their personal tax return.
How Partner Draws Affect Your Tax Responsibilities
Like sole proprietorships, partners can easily transfer funds from the business bank account to their accounts without immediate income tax consequences.
Regardless of whether you withdraw or leave the profits in the business, you must report and pay taxes on the business’s profits. This method of compensation is known as a “partner or member draw,” and it is not reflected in the business’s profit and loss statement.
It’s important to note that this draw is also non-deductible.
Compensation Through Guaranteed Payments
Alternatively, partners can receive compensation through Guaranteed Payments, which can be distributed equally or unequally.
Guaranteed Payments allow for compensating a partner who actively works in the business, even if they have the same ownership percentage as a non-working partner.
These payments are treated as business expenses in the profit and loss statement and are reported as income by the partner receiving them.
Never make the costly mistake of putting partners on the partnership's payroll.
Partners should never receive salaries or wages reported on a Form W-2.
Doing so can trigger significant overpayments of non-refundable Social Security and Medicare taxes. The IRS emphasizes this point, as partnership income, including guaranteed payments, is subject to self-employment taxes and federal income taxes.
How To Pay Yourself As A Business Owner Of An S Corporation Owner
When you're an owner of an S corporation, which can include LLCs that have elected to be taxed under subchapter S, it's essential to pay yourself a reasonable salary for the services you provide. This is a key aspect of operating an S corporation.
Once you've paid yourself a reasonable salary, any additional profits can be distributed to owners as stockholder distributions, which are not subject to payroll or self-employment taxes.
S corporations are required to file a separate tax return, and the business's profit or loss is passed through to the owners via Schedule K-1.
What Is a Reasonable Salary for S Corporation Owners?
If the S corporation isn't profitable, there is no requirement to pay a salary to its owners.
The term “reasonable salary” can be subjective, but it should be comparable to what you would pay someone else to perform the same services you provide for the business.
Generally, the maximum salary that needs to be paid would be up to the Social Security wage limit ($168,600 for 2024), though lower amounts may be appropriate depending on your specific circumstances.
Owner salaries are treated like any other business expense; they are included in the profit and loss statement and deducted as expenses on the tax return.
What are Stockholder Distributions?
After paying yourself a reasonable salary as an S corporation owner, any additional profits can be distributed to owners as stockholder distributions.
The key benefit of these distributions is that they are not subject to payroll or self-employment taxes, making S-corporations an attractive option for business owners.
S-corporations must file a separate tax return, and the business's profit or loss flows through to the owners on Schedule K-1. Owners must report and pay taxes on the business’s profits, whether or not those profits are withdrawn.
Tax Implications of Stockholder Distributions
Once a salary has been paid, the remaining profits can be distributed to owners without further tax consequences.
As with sole proprietorships and LLCs, owners can transfer these funds from the business bank account to their personal accounts, usually without any income tax effects.
These transfers, known as stockholder distributions, are not reflected on the business’s profit and loss statement.
The Role of Basis in Stockholder Distributions
One limitation to consider is the concept of basis—essentially, the amount of your investment or "skin in the game" in the business.
Your basis determines how much you can take in distributions without additional tax consequences. This concept is handled differently in partnerships and S corporations, so it’s important to understand how basis impacts the distributions you receive.
How to Track Basis
For partnerships/LLCs and S corporations, your basis in the business is an important consideration when getting money out of the business. You should track your basis as part of your annual income tax preparation process.
In general, if you don’t withdraw more money than you put in, plus the business’s taxable profits, the basis won’t ever be an issue for you.
For S corporations, borrowed money does not increase your basis, so if you withdraw borrowed funds, there could be a basis issue. If withdrawals are greater than your basis, you could have to pay capital gains tax on the excess withdrawals, so please consult your tax advisor when making withdrawals in excess of profits.
Equal Distributions Among S Corporation Owners
Unlike partnerships, S corporation distributions must be paid to all owners according to their ownership percentages. If distributions are unequal, it will void the business’s S-election.
How to Pay Yourself as a C Corporation Owner
So, you’re a corporation, or an LLC that has made an election with the IRS to be taxed as a C-corporation.
C corporation is the default tax classification for corporations unless they elect S status. Unlike other entities, C corporations file their own separate tax return and pay their own taxes—profits or losses do not flow through to the owners.
This structure is generally unattractive to small business owners since there are limited ways to withdraw profits from the business without paying additional taxes on the funds.
The Most Common Way Owners Of C Corporations Withdraw Funds Is Via Salaries of the Owners.
Salaries are reported as expenses of the business on the company’s profit & loss statement and tax return. Payroll taxes are paid on the owners’ salaries as with any other employee and they report the salaries via Form W-2 on their personal tax returns.
The IRS takes the opposite view from S corporations on salaries for C Corporation owners – they want to keep the salaries to a minimum.
They want reasonable salaries to be as low as possible since the net effect is neutral when calculating income taxes (the deduction to the business is offset by the income to the owner). This is a common audit issue, and C corporations typically face higher audit rates than flow-through entities, such as LLCs and S corporations.
Distributing Additional Profits Through Dividends
After salary payments have been maximized, the corporation can pay dividends to its owners according to their ownership percentages. However, dividends are not deductible to the corporation but are taxable to the owners, leading to a second layer of taxation. Owners generally pay tax on the dividends at the lower tax rates applicable to qualified dividends (capital gains tax rates).
Retained Earnings: Watch Out for the Accumulated Earnings Tax
Leaving extra profits in the C corporation as retained earnings might sound like a good idea, but it comes with a risk.
If owners leave excess amounts in the C corporation as retained earnings instead of withdrawing them as dividends or salaries, the IRS may impose an Accumulated Earnings Tax.
This tax encourages companies to pay out dividends, which are double-taxed, rather than retaining their earnings. To avoid this tax, the business must demonstrate that the retained funds are necessary to meet its business needs.
Other Methods of Withdrawing Funds
Owners can withdraw funds indirectly by having the business cover certain expenses that also benefit them.
This includes vehicle-related expenses, retirement benefits, health insurance payments, cell phone benefits, internet expenses, etc… Please consult your tax advisor for additional information if needed.
Keep Personal and Business Expenses Separate
Remember: For all these forms of business, it is never a good idea to pay for personal (non-business related) expenses directly from your business bank accounts. It’s always better to transfer money to your personal accounts and then pay your expenses from there.
Don't Let Confusion Cost You, We're Here to Help
There are tons of questions that come to mind when you start running a business for the first time, like What Insurance Policies Do I Need?
Paying yourself, or getting money out of your business, is one of those many simple, yet potentially confusing processes that you want to get right. Hopefully, this article helped you classify where you stand in your own business. If you still have questions, feel free to reach out to us by clicking the button below!
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