How do I pay myself as a small business owner?

One of the most common questions business owners ask is, "How do I pay myself?" While the answer may seem simple, the method you use to take money out of your business depends largely on how your business is structured for legal and tax purposes.

A sole proprietor, partner, S-corporation shareholder, and C-corporation owner may all receive pay (compensation) differently, and each method comes with its own rules and tax reporting requirements. Choosing the wrong approach can lead to tax issues, payroll compliance problems, or missed planning opportunities.

In this topic, we'll provide a high-level overview of the most common business entity types, how owners are typically paid, and the general tax implications of each compensation method.  Understanding these fundamentals can help you have more informed discussions with your accountant and make better business decisions.

Before determining how to pay yourself, it is important to understand the difference between a business's legal entity and its tax classification.  In some cases, they are the same.  In others, a business may elect a different tax treatment with the IRS, which can significantly change how owners’ pay is handled.  Why does the business legal entity affect the owner's pay?  It's because the IRS has different rules and regulations for each legal entity tax classification that must be followed.  All entities have their purposes, benefits, costs, limitations, and regulations.  This topic won’t go into the details of the purposes, pros, cons, limitations, and regulations for each entity, the possible tax savings, or how much to pay yourself, as these are separate topics.  There are 4 common types of legal entities that business owners establish.

Legal Entity	1) Sole Proprietorship	2) Partnership	3) Corporation	4) LLC (Limited Liability Company)
Legal Entity Options	Sole Proprietorship	General Partnership Limited Partnership Limited Liability Partnership	Corporation	Single Member LLC Multi-Member LLC

Here is a high-level overview of the most common business entity types, how owners are typically paid, and the general tax implications of each compensation method.

IRS Tax Entity Classification	Sole Proprietorship	Partnership	S-corporation	C-corporation
Legal Entity	Sole Proprietorship Single-Member LLC (no election)	General Partnership Limited Partnership Limited Liability Partnership Multi-Member LLC	Corporation (elected) LLC (elected)	Corporation LLC (elected) Sole Proprietorship (elected) Partnership (elected)
How to pay myself?	Owner’s Draw	Guaranteed Payments Partner Draws	Payroll W-2 (Reasonable compensation) Distributions	Payroll W-2 (Reasonable compensation) Dividends
How is the owner’s pay taxed?	The Owner’s Draw is subject to income and self-employment taxes	The Partner’s Draw is usually subject to income and self-employment taxes (similar to sole proprietorship) for active partners The Partner Draws are usually not subject to self-employment tax for passive partners	The Payroll (W-2) is subject to income and payroll taxes The Distributions are not subject to payroll taxes Distributions are not subject to double taxation if they come from profits of the business which are already taxed	The Payroll (W-2) is subject to income and payroll taxes The Dividends are subject to income tax but not payroll taxes C-Corporate profits may be taxed twice: once at the corporate level and again when dividends are paid to owners  and reported on their personal tax returns.
When are taxes paid?	Paid through quarterly tax estimates and when the personal tax return is filed	Paid through quarterly tax estimates and when the personal tax return is filed	For Payroll (W-2), taxes are withheld from your pay and paid based on a IRS payroll tax deposit schedule (most common is semi-weekly) For Distributions, taxes are paid through quarterly tax estimates and when the personal tax return is filed	For Payroll (W-2), taxes are withheld from your pay and paid based on a IRS payroll tax deposit schedule For Distributions, taxes are paid through quarterly tax estimates and when the personal tax return is filed
How is the pay reported?	Reported with the personal income tax return	Reported with the partnership tax return which then passes through to the personal tax return	For Payroll, the wages are reported via W-2 For Distributions, they are reported via Form K-1, reported with the S-corporation tax return which then passes through to the personal tax return	For Payroll, the wages are reported via W-2 For Dividends, they are reported via Form 1099-DIV, reported separately from the C-corporation tax return, which is then reported on the personal tax return

• How do fringe benefits affect pay?

  • Fringe benefits are another topic, but they can affect the owner's pay, tax, and reporting.

• What is the difference between Payroll (W-2) and Distributions (dividends)?

  • Payroll is the payment to an employee by a business that is subject to income and payroll taxes, such as Social Security and Medicare, and is reported to the IRS on an annual W-2.

  • Distributions are payments made to owners from business profits or capital.  In a C-corporation, these payments are generally referred to as dividends.

• What is reasonable compensation?

  • It is the IRS rules surrounding how much you should pay yourself through Payroll as an owner when you own an S-Corporation or C-Corporation

• What about multiple investors or partners?

  • If your business is a partnership with multiple partners, or an S-corporation or C-corporation with multiple investors, you may have to follow the operating agreement established for the business, which may dictate how to pay the partners or investors.

• What about passive partners or investors?

  • Passive investors or partners are not usually subject to self-employment taxes (partnerships) or payroll (W-2) for S-corporations and C-corporations.  They should only be paid distributions.

• What about paying employees?

  • Employees are paid through payroll (W-2), not with distributions.

• What happens if I don't have basis or at-risk money in the business?

  • This is something you should work with your tax preparer (accountant) on, as this may cause tax issues with paying distributions.

• What about state laws?

  • State tax laws and payroll requirements may differ from federal rules.  Business owners should consult their accountant or tax preparer regarding state-specific requirements.

• Given the complexity of federal and state rules and regulations for determining the type of entity you are and for matching pay methods, reporting, and paying taxes, we recommend working with an accountant.

In Summary

How you pay yourself depends on your business’s legal entity and tax classification. Sole proprietors and many partners usually take owner draws or distributions. S corporation and C corporation owners often get paid through payroll and sometimes distributions.

Each business type has its own tax rules, reporting needs, and compliance steps, so there isn’t one right way to pay owners. Things like reasonable pay, active or passive ownership, operating agreements, basis limits, and fringe benefits all play a role.

Before making changes to your compensation, it is important to understand the legal and tax implications.  Working with a qualified accountant or tax professional can help ensure that your compensation strategy is compliant, tax-efficient, and aligned with your business goals.

Disclaimer

Our firm provides this information for general educational guidance only and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.