Running a business is a lot of work—and as a small business owner, you need to get paid for your time, energy, and efforts.
But paying yourself as a small business owner isn’t as cut and dry as paying your employees. There are a few different options when it comes to how (and how much) you pay yourself, and it’s important to understand those different options—and how to determine which option is the best for you and your business.
Let’s take a look at the different ways to pay yourself as a small business owner—and how to determine which payment option is the right fit for your business.
Understanding business structures
How you structure your business will play a huge role in determining how to pay yourself—so before we jump into how to pay yourself as a business owner, let’s quickly review the different business entities.
There are a few different ways you can structure your business, including:
- Sole proprietorship. If your business is structured as a sole proprietorship, you’re what’s considered a pass-through entity by the IRS. Essentially, as the sole owner of your business (this structure is common with freelancers), all of the profits of your business are “passed through” to you.
- Partnership. If you have a partnership agreement and other co-owners in your business, you’re considered a partnership. Partnerships are also considered pass-through entities by the IRS—except instead of all the business profits being passed through to a single person, they’re passed through to all owners in the partnership.
- S corporation. Many business owners elect to structure their business as an S corporation for tax purposes (as this business structure can offer certain tax benefits to business owners). S corps are also considered pass-through entities, as owners don’t pay taxes on their profits through their business—and instead, include their business income on their personal tax return.
- C corporation. C corporations are not a pass-through entity and have a more complex tax structure; they’re responsible for paying taxes on their business tax return and, depending on if/how they pay themselves, business owners may also be responsible for paying additional taxes on their personal tax returns.
- Limited Liability Company (LLC). Creating an LLC offers business owners a lot of flexibility. Depending on your business structure, LLC owners could be seen and taxed by the IRS as a sole proprietorship, a partnership, or an S corp—and you also have more flexibility when it comes to how you pay yourself.
Because of the way different business structures are taxed, the business entity you choose will determine the right way to pay yourself as a business owner.
As mentioned, there are a few different ways small business owners can pay themselves, including:
Owner’s draw
When you take an owner’s draw, you’re taking money from your business (or “taking a draw”) for your own personal use. Sole proprietors and single member LLCs can all pay themselves using the owner’s draw model.
The major benefit of taking an owner’s draw? Flexibility. Paying yourself through the owner’s draw model offers a lot more flexibility than a salary. When you take an owner’s draw, you can take as much or as little as you’d like—and you can draw from your business account frequently, infrequently, on a regular basis, or more randomly; it’s really up to you, when you need money, and how much you need.
If you decide to go with this model, it’s important to note that the money you pay yourself through an owner’s draw isn’t taxed—so you’ll need to set aside money for self-employment taxes and estimated taxes on your own.
Salary
When you pay yourself a salary, you’re considered a W-2 employee—and just like other employees, you get paid a set amount on a regular schedule (for example, $7000 once per month or $3500 bi-weekly).
One of the major benefits to paying yourself a salary is that taxes (for example, Medicare, FICA taxes, payroll taxes, and social security) are automatically withheld—which gives you, as a business owner, one less thing to think about.
Distributions or dividends
Distributions are cash payouts from a business to the owner. Owners of a partnership pay themselves through distributions—and owners of S corporations can take distributions in addition to their salary. Owners of C corporations can also receive cash payouts from their businesses, which are called dividends.
Similar to owner’s draw, distributions aren’t taxed—and, as a business owner, you’ll be responsible for paying those taxes on your own.
Things to consider when paying yourself as a small business owner
Now that you understand the different ways to pay yourself (and which payment structure aligns with which business entity), let’s cover a few things you’ll want to consider when paying yourself as a small business owner.
- Separate your business expenses and personal expenses. If you pay using the owner’s draw method, it could be easy to mix your business income and business expenses with your personal income and personal expenses (since you’re just using your business money to pay yourself). But make sure to separate the two, including keeping separate bank accounts (both a business bank account and a personal bank account). The last thing you want to deal with is trying to figure out what expenses were business-related and which were personal at the end of the year—and then trying to get those transactions organized come tax time.
- Pay yourself a reasonable salary. If you pay yourself using the salary and distribution model, it’s important to pay yourself a reasonable salary—and not take the majority of your payment through large distributions. Taking a small salary and large distributions can trigger an audit from the IRS—and if they determined you didn’t pay yourself appropriately, you could find yourself dealing with a large tax bill. (Reasonable compensation levels for a salary will depend on your industry and job responsibilities. If you’re unsure what salary you should aim for, talk to your accountant.)
- Set aside money for taxes. As mentioned, owner’s draw and distribution monies aren’t automatically taxes—so if you pay yourself through either of those models, it’s important to set aside money for taxes.
- Monitor your cash flow. However you decide to pay yourself as a business owner, it’s important to ensure you have enough cash on hand to support your business operations—so make sure to regularly review your balance sheet and ensure that your owner payments are in line with your available cash.
