How do business owners pay themselves?
You’ve done it! Your business has finally made some money. Now, how do you pay yourself?
This is an important decision because it can impact your taxes & legal protections if you take the wrong step. The method varies depending on your business structure, so we dive into each below.
Sole Proprietorship / Single Member LLC
The IRS views sole props (i.e. having no entity) and single member LLCs (i.e. having only one owner) as what’s called “disregarded” entities. That means, the individual and the business are the same for tax purposes.
How to Pay Yourself: Owners pay themselves by taking what’s called a “draw.” This means you can, at any point, transfer money directly from your business account to your personal account.
Tax Implications: Taking a draw has zero impact on your taxes. That means whether you leave the profit in your business bank account, or take a draw for every dollar of profit, you’re paying the same amount of tax.
Other notes: A “draw” is not an expense to the business, so it does not reduce net profit. Owners also cannot issue W-2s to themselves, though they can hire other W-2 employees that they pay.
Multi-Member LLC / Partnerships
MMLLCs and Partnerships are pass-through entities, meaning the business's profits or losses pass through to the owners and are taxed on their personal returns.
How to Pay Yourself:
(1) Guaranteed Payments - Partners cannot be employees of their own business, or issue themselves a W-2. However, they can agree to provide “Guaranteed Payments” to partners as a “salary”
(2) Owner Distribution - Partners are also able to distribute funds, taking what’s called an “owner distribution.” This means you can, at any point, transfer money directly from your business account to each of the partner’s personal accounts.
Tax Implications:
(1) Guaranteed Payments - These work similarly to a W-2 in that the business gets a deduction and the partner’s report guaranteed payments as income on their 1040.
(2) Owner Distribution - The business gets no deduction for distributions, as it’s not an expense to the business. Therefore distributions have zero impact on the business’ taxes. Additionally, the partner typically has no tax liability for distributions they receive (as long as they have enough basis in the entity, which is a topic for another post).
Strategy: It’s typically preferable to have lower guaranteed payments as it reduces payroll taxes.
Other notes: Owners can not issue W-2s to themselves, though they can hire other W-2 employees that they pay.
S Corporations
Similar to the MMLLC above, an S corporation is a pass-through entity, meaning the business's profits or losses pass through to the owners and are taxed on their personal returns. However, the main difference with an S corp is that an actively involved owner is also considered an employee of the business.
How to Pay Yourself:
(1) Salary - An S corp owner/employee must pay a “reasonable salary” and issue themselves a W-2 for their earnings. This is one of the reasons S corps are a little more complex to manage, as you need to actively run payroll.
(2) Owner Distribution - S corp owners are also able to distribute funds, taking what’s called an “owner distribution.” This means you can, at any point, transfer money directly from your business account to each of the partner’s personal accounts.
Tax Implications:
(1) Salary - The salary an owner earns will be deducted as an expense by the business. S corp owner/employees will report their salary as income on their 1040.
(2) Owner Distribution - The business gets no deduction for distributions, as it’s not an expense to the business. Therefore distributions have zero impact on the business’ taxes. Additionally, the partner typically has no tax liability for distributions they receive (as long as they have enough basis in the entity, which is a topic for another post).
Strategy: It’s typically preferable to have a lower salary as it reduces payroll taxes. However, the salary still needs to be “reasonable” given the owner/employee’s role.
Other notes: Owners must issue W-2s to themselves, though distributions are optional.
C Corporations
A C corporation is a separate legal entity from its owners, and the way you pay yourself is different from other business types.
How to Pay Yourself:
(1) Salary - A C corp owner can pay themselves a salary, and will issue a W-2 for their earnings. This is one of the reasons C corps are a little more complex to manage, as you need to actively run payroll.
(2) Dividends - C corp owners are also able to distribute accumulated profit to owners, taking what’s called an “dividend.”
Tax Implications:
(1) Salary - The salary an owner earns will be deducted as an expense by the business. C corp owners will report their salary as income on their 1040.
(2) Dividends - The business gets no deduction for dividends. Therefore dividends have zero impact on the business’ taxes. However, any owners who receive dividends will report these as income on their 1040.
Strategy: W-2 income is subject to self-employment & ordinary income tax. This may be less preferable than dividends, which can be taxed at preferred capital gains rates (if the corporate stock was held > 1 year).
Other notes: Owners typically issue W-2s to themselves, and dividends are optional.
Key Takeaways:
Choosing how to pay yourself depends on your business structure, tax goals, and personal financial needs. Here's a quick recap:
Sole Proprietorship: Owners take a draw at any point; taxes are paid on net business profits, so draws do not effect taxes.
MMLLCs/Partnerships: Both guaranteed payments (similar to a W-2 salary) and distributions. Guaranteed payments will be taxable, distributions typically not.
S Corporations: Both a salary and distributions. Salary will be taxable, distributions typically not.
C Corporations: Both a salary and dividends. Both a salary and dividends are taxable.