How to Pay Yourself as a Small Business Owner

As an entrepreneur, you have endless ways and options to run your small business. 

But when it comes to how to pay yourself as a small business owner, your choices get narrowed down.

In fact, most small business owners get paid in one of two ways: owner’s draw vs. salary.  

While it may be tempting to quickly select one method over the other, patience is paramount. Before moving ahead, it’s important to investigate the differences between the two options so you can make the most informed decision, according to what’s right for you and your business.

It’s also important to know what the IRS has to say about the matter. After all, your chosen compensation method must be fully compliant with tax laws, while also fueling the long-term success of your small business. 

Ready to learn more? Here’s everything you need to know about how to pay yourself as a small business owner.

Why Payment Structure Matters

If you’re like most entrepreneurs, you work long hours—sometimes well over 50 a week. 

Whether you’re at home or the office, or whether it’s a Saturday or a Monday, your small business is always top of mind. After all, you’re constantly looking for new ways to improve your product line, to enhance your branding, and to boost your sales.

Amid these ceaseless demands, it can be easy to overlook the essentials, like how to pay yourself as a small business owner. After all, you have bills to pay outside work.

While your compensation method might seem insignificant, it’s more important than it appears. In fact, the way you get paid will have a defining effect on your business and personal finances. 

When you make the right choice for you and your small business, you can maximize cash flow, save on taxes, and avoid personal liability for business debts. 

Fortunately, you don’t need to compare endless compensation methods. You just need to decide between two: owner’s draw vs salary. 

Understanding Owner’s Draw

An owner’s draw is when an entrepreneur voluntarily takes money out of their business. 

Through this compensation method, business owners can conveniently pay themselves without issuing a fixed salary or withholding employment taxes. Plus, they can do it at any time.

Instead, an owner’s draw allows entrepreneurs to routinely write themselves a check from their business checking account, to debit funds from an ATM, to transfer money from their business account to a personal account, or to even take cash straight out of the register. 

It may sound like a compelling compensation method, but an owner’s draw can introduce complications. 

Above all, it can instigate cash flow problems if too much money is taken out of the business over a short period of time (or during an unexpected downturn). So while an owner’s draw is undefeated for ease-of-access, it can be risky for budgeting.

There are also important tax implications to consider. 

Though an owner’s draw is not subject to payroll taxes (like Medicare and Social Security), owners are still held responsible for paying income taxes on their draw.  

That’s because the Internal Revenue Service (IRS) considers an owner’s draw to be a form of personal income—and as you know, all personal income gets taxed.

It’s also important to note that some businesses are ineligible for the draw method. In fact, only three business structures allow for owner’s draws: 

• Limited Liability Companies (LLCs), which can choose either the owner’s draw or regular salary method. For single member LLCs, the draw method generally offers greater control over business profits. However, corporate LLCs with higher tax burdens may prefer the reliability of the salary method.
• Sole proprietorships, where an owner’s draw is the only option for compensation.
  If you’re self-employed, you cannot legally pay yourself using a W-2 salary. In fact, the IRS considers all business profits to be personal income, and that’s what gets taxed.
• Partnerships, which are also required to use the draw method. Why? Because you legally can’t be considered both a partner and an employee. Therefore, the IRS taxes partnerships just like sole proprietors: for your percentage of the partnership’s income. 

Finally, it’s important to note that owner’s draws are not available to C Corporations (C Corps), as they are taxed independently of any owners or shareholders. Instead, C Corp owners can receive compensation through dividend distributions and salaries (as we will discuss below). 

Understanding Salary

A salary refers to the fixed and recurring amount of money a business owner pays themselves.  

An entrepreneur’s salary is delivered every pay period (i.e. weekly, bi-weekly, monthly). That’s why a salary is so popular among businesses: because it’s predictable and requires very little administrative work. 

Plus, when you work with a reliable payroll provider, taxes are withheld automatically from each paycheck (unlike owner’s draws). This advantage can help shield your business from potential IRS troubles come tax season. 

Beyond these immediate benefits, taking a salary can also make it easier to budget and manage your company’s cash flow.

Instead of taking out money at will (as an owner’s draw allows), a salary has limitations. Therefore, it can provide greater consistency so you always know what’s flowing in and out of your business. 

When times are good, you can give yourself a pay raise. During slower seasons, you will have the option of taking a pay cut and reinvesting those funds back into your business. 

S Corp and C Corp owners are required to take their income through a salary, rather than the draw method. Per IRS regulations, S Corp and C Corp business owners must pay themselves a ”reasonable” salary according to their job duties and skills.

However, both S Corp and C Corp owners can also take distributions above their salary. Though technically the same thing as a draw, distributions are the preferred IRS terminology used on tax forms (like the K-1). 

Generally speaking, distributions from company earnings are taxed at the owner’s personal rate. Therefore, the owner has the ability to split their income however they choose. 

For example, let’s say an entrepreneur of an S Corp receives a total compensation of $50,000.
Of that payout, she takes $30,000 as salary and the remaining $20,000 from distributions. 

Ultimately, this combination can help business owners save big on their income tax returns. 

The IRS does not provide specific guidelines for how much you can take in distributions. Nevertheless, S Corp business owners are advised to follow the “60/40” salary rule—as shown in the example above—to avoid triggering an IRS audit. To that end, any attempt to disguise salary as distributions could incur punitive tax penalties from the IRS. 

Choosing the Right Method for Your Business

It can be hard to decide how to pay yourself as a small business owner. 

As we have seen, your choice involves complexities on multiple fronts, including your business cash flow, your personal finances, and the intricacies of U.S. tax laws. 

From a high-level view, the differences between owner’s draw vs salary are as follows:

While Limited Liability Companies (LLCs) enjoy the most optionality, many business classifications do not allow a choice between owner’s draw vs salary. 

Therefore, determining your business structure is the single biggest factor in deciding how to pay yourself as a small business owner.

To review, these are the recommended payment methods for the following business structures: 

• Sole proprietorship, a business structure with no legal separation from its owner: owner’s draw method. 
• Partnership, a business with two or more owners: owner’s draw method. 
• S-Corp, a business entity that does not pay dividends to the owners: salary method, with “reasonable” distributions allowed. 
• C-Corp, a business corporation that pays taxes on profits: salary method, with taxable distributions allowed. 
• Not-for-profit, a tax-exempt organization that offers public or social benefit: salary method, with compensation approved by an independent third-party to avoid IRS investigation. 
• Single member LLCs, entities that exist independently of its owner/owners: owner’s draw method. 
• Larger LLCs, or LLCs in states with stiff tax regulations: salary method. 

As you investigate your options, we encourage you to consult with a financial advisor along the way. Their expertise can help you maximize your earnings and ensure no money is left on the table. More importantly, financial professionals can help defend your personal and business financial interests against potential legal and tax vulnerabilities. 

uLink: Your Partner in SMB Success

Entrepreneurs like you are in the business of problem-solving. 

Every day, you face revolving challenges as you consistently turn each no into a resounding yes. That’s why you deserve to get paid in the most rewarding (and reliable) way possible. 

As you decide how to pay yourself as a small business owner, uLinkbusiness is committed to delivering the one-stop solution for all of your B2B payment needs. 

Need to pay invoices and suppliers? Got it.

Need to buy inventory? Done.

Processing international payroll? Easy. 

Paying international service providers? We do that too. 

Plus, when you partner with uLinkbusiness, you can confidently avoid international fees, enjoy special exchange rates, and complete payments within 1-2 business days. 

Discover what we can do for your small business.