How to Pay Yourself as a Small Business Owner
Business owners should pay themselves if their business earns enough money to do so. Aside from affordability, there are also tax considerations and different payment methods to consider, depending on how you’ve structured your company.
We’ll help you decide when and how to pay yourself the right way.
How do small business owners pay themselves?
When you do decide to pay yourself, it’s not as easy as just opening the cash register and taking out money. Business owners should pay themselves correctly by following a few steps.
Step 1. Determine your business entity
How you pay yourself will be determined by your business entity. As an example, someone who runs a sole proprietorship will pay themselves differently than someone who runs an S corporation.
As a sole proprietor, you are the only owner of your business. A sole proprietorship is a pass-through entity, meaning that all profits are passed through to the business owner. Rather than paying yourself a regular paycheck as an employee, you’ll pay yourself an owner’s draw. That can be as simple as writing yourself a check or doing an automated clearing house (ACH) transfer — we’ll cover those details, below.
In a partnership, unlike a sole proprietorship, there is more than one owner. However, like a sole proprietorship, it’s also a pass-through entity, and thus all profits will be passed through to the partners. Partners are not employees paid a salary, but they do pay themselves with an owner’s distribution.
What percentage of the profits does each partner receive? And how often are the profits distributed? How these distributions are handled should be clearly spelled out in your company’s partnership agreement.
A limited liability company (LLC) gives flexibility. Single-member LLCs are usually treated as sole proprietorships by the IRS, and are what’s known as disregarded entities. LLCs with multiple members are treated as partnerships, and their owners are paid either through an owner’s draw or distribution.
The exception is if an LLC chooses to be taxed as an S corp or a C corp; in that case, the owner will be paid as an employee. In addition, they can also be paid through shareholder distributions or dividends.
An owner of an S corporation that works in the business is considered an employee and should be paid a W-2 wage. That means that rather than paying oneself through an owner’s draw or distribution, they’ll be paid reasonable compensation. If, however, the owner only performs minor services (or doesn’t perform any services at all) and doesn’t receive any pay, they aren’t considered an employee. We’ll talk more about what the requirements for a reasonable salary are in a later section.
On top of the reasonable compensation, an owner can receive shareholder distributions. There are some tax benefits to structuring your company as an S corporation because the distributions aren’t subject to self-employment tax, whereas owner’s draws or distributions that are taken in a sole proprietor or a partnership are subject to self-employment tax.
Just as with a S corporation, owners of a C corporation who work in the business are considered employees and are paid as W-2 employees. In addition to their salary, they can also be paid in dividends. Dividends received are also included in the shareholder’s (in this case the owner’s) taxable income.
|How to Pay Yourself as a Business Owner|
|Entity Type||Payment||Tax Form||Self-Employment Tax|
|Sole Proprietorship||Owner’s draw||Schedule C Form 1040||Yes|
|Partnership||Owner’s distribution||Schedule K-1 Form 1065||Yes|
|Single Member LLC (classified as a disregarded entity)||Owner’s draw||Schedule C Form 1040||Yes|
|Multi-member LLC (classified as a partnership)||Owner’s distribution||Schedule K-1||Yes|
|S Corporation||Salary and shareholder’s distribution||W-2 for salary
Schedule K-1 Form 1120S for distributions
|Payroll taxes as an employee|
|C Corporation||Salary and shareholder’s dividends||W-2 for salary
1099-DIV for dividends
|Payroll taxes as an employee|
Step 2. Determine how much you should pay yourself
When it comes time to decide how much you can pay yourself, there are a few things you’ll want to consider:
How much do you need to earn?
You can’t be expected to live without earning an income. Hannah Smolinski, CEO of Clara CFO Group, recommended paying yourself consistently, at least monthly.
“What do you need to cover your personal expenses?” she said. “If your business is your only source of income, you need to figure out exactly what number that is that you need to be taking home on a monthly basis.”
Average small business owner salary
How much you can pay yourself depends on both the income in your business and your lifestyle needs. Don’t forget to set aside money to cover income taxes and self-employment taxes, if applicable. Plus, you might also need to set aside funds for future growth and business emergencies. Setting aside money for those expenses reduces how much you can pay yourself, which may be more or less than the average entrepreneur salary.
Depending on how much your business earns, there may be a period of time where you’re cutting back on your personal spending because your business can’t support paying you enough.
What is “reasonable” compensation?
The IRS requires that officers of a corporation be paid a reasonable compensation that corresponds with your responsibilities or duties. Smolinski said that most tax accountants will want you to come up with your reasonable compensation amount by either:
- Looking at what it would cost pay someone else to do the work that you do, or
- Estimating the fair market value of the services you provide.
“If there was a highly-skilled CEO making $25k per year in salary, that would be a huge red flag,” said Smolinski. “Conversely, a convenience store owner who works the counter most of the time might be able to get away with a reasonable comp closer to a minimum wage job.”
What are your company’s plans?
It may be tempting to cut yourself a substantial paycheck, especially after years spent putting your livelihood on the line to launch a business. But when it comes to deciding how much you should pay yourself, the main factor an entrepreneur should consider is practicality, advised Simon Mahler, a mentor for SCORE, a national nonprofit that connects small businesses with free expertise.
“We all have expenses in life,” he said. “You have to realize that what you take for yourself as a salary takes from the business.”
If your company is rapidly growing, you may want to hold on to any “extra” cash flow, in case you need to fund a project. In that case, you might not want to take a draw in addition to a base salary, or a larger salary than you need, to cover your basic needs. As the company earns more profit, you can give yourself raises, accordingly.
Step 3. Establish a payment method
Now that you know how much you’re going to pay yourself, it’s time to figure out the mechanics of how to actually do that.
Separate business and personal finances
Your business finances and personal finances should be kept separately, and a good way to do this is by opening a business checking account. Even as a sole proprietor, you’ll want to keep your money separate because it helps maintain accurate recordkeeping (which will help at tax time) and increases the professional appearance of your business.
Pay yourself consistently
According to Smolinski, one of the best things you can do when determining your payment schedule is to pay yourself consistently. Whether that be monthly or more, that consistency helps with planning, both personally and in your business. When you pay yourself consistently, you have a better handle of what your business cash flow needs are.
Use ACH payments or checks
For business structures where you take owner’s draws or distributions, paying yourself can be as simple as writing yourself a check or making an ACH transfer from your business bank account. But don’t get too casual with taking money out of your business — it needs to be properly recorded in your bookkeeping. An owner’s draw, for example, would be recorded on your balance sheet and owner’s equity statement under your owner’s equity account.
Consider a payroll service
If you’re paying yourself a salary because your business is an S corporation or a C corporation, withholding for taxes can get tricky. Rather than doing it yourself, Smolinski recommends using a payroll service to handle it for you.
“You do need to be on some sort of payroll system in order to properly document all the taxes, make sure they’re properly withheld and also remitted to the right agencies at the right time,” she added.
Small business owners have a lot of different tax considerations, but there are a few that you’ll want to keep top of mind as you start paying yourself.
One thing that may come as a surprise to many business owners paying themselves for the first time is that they won’t just be responsible to pay income tax on their earnings: they’ll also need to pay Social Security and Medicare taxes.
As an employee, these taxes are split between you and your employer and withheld from your paycheck. When you are self-employed, you’re responsible for paying the entire tax and remitting the required payments yourself.
The current self-employment tax rate is 15.3%, which is made up of 12.4% for social security and 2.9% for Medicare. The social security tax only applies to the first $137,700 of your combined earnings for 2020. Your combined earnings includes all of your wages, tips and net earnings for the current year.
Federal income tax
The U.S. tax system is a pay-as-you-go tax system. Rather than making one tax payment at the end of the year, the IRS requires multiple tax payments to be made during the year.
Business owners who are paid a salary for their work, because their business is an S corporation or a C corporation, have income taxes withheld from their paychecks. Business owners who don’t receive a salary need to make estimated tax payments quarterly. Estimated tax payments need to be made to the federal government. If your state has state income tax, you’ll likely need to make estimated tax payments to your state as well.