Find the best business loan rates (2021)

How to Pay Yourself as a Business Owner: Which Way Will Save You Most on Taxes?

By Roy Rasmussen Reviewed By Mike Lucas
By Roy Rasmussen
By Roy Rasmussen Reviewed By Mike Lucas

Knowing how to pay yourself as a business owner is essential for financial planning and tax preparation.

Here’s what you need to know about:

  1. Payment methods: owner’s draw vs. salary vs. distribution vs. dividends
  2. How your business structure affects your payment method
  3. How payments affect equity
  4. How your payment method affects your tax liability
  5. How much to pay yourself
  6. How to record payments to yourself for bookkeeping
  7. How to report payments to yourself for taxes

Read on to learn the best way to handle paying yourself when you’re a business owner so you can keep more of what you earn.

1. How Do Small Business Owners Pay Themselves?

It basically comes down to owner’s draw vs. salary vs. distribution vs. dividends. Indeed, small business owners typically pay themselves using 1 of 4 methods:

  • Drawing from company funds (owner’s draw)
  • Paying yourself a salary as a company employee
  • Distributive shares, also known as distributions
  • Dividends

Of these, the first 2 are most relevant for most small business owners. We’ll focus on these, but we will also cover the other methods briefly so that you are aware of them.

Owner’s Draw

With an owner’s draw, you pay yourself with funds from company accounts. The funds may come from capital contributed to the company or they may come from profits generated by operations.

Funds may be withdrawn directly from company accounts and used for personal spending, or they may be transferred to personal accounts and then used. For example, if a business owner used a company checking account to pay for a personal expense, this would be a direct withdrawal from company funds for personal use.

On the other hand, the owner might write themselves a check to be deposited into their personal account for later spending. This method is better for bookkeeping because it makes it easier to track business expenses separately from personal spending.

Business Owner Salary

With a business owner salary, characteristic of C corporations (corporations that get taxed separately from their owners’ personal taxes), you treat yourself as an employee and pay yourself the same way you would pay other workers. As with a normal employee, your paychecks reflect deductions for tax withholdings and benefits such as 401(k) plans.

Payments are made according to a regular schedule. They can be transmitted electronically through direct deposit or paid by physical check.

Distributive shares

Distributive shares are used with partnerships, with limited liability companies (LLCs) which have multiple members and with shareholders in S corporations (corporations that don’t get taxed but pass tax liability on to owners).

With this method of payment, each recipient receives a distribution that reflects a percentage of company profits. How distributions are divided is based on a contractual agreement. For example, a pair of partners may agree to distribute profits 50-50.

Dividends

Dividends are used for owners who are nonemployee shareholders in C corporations. Dividends are paid out of company profits and are divided up proportionate to the number of shares a shareholder holds.

Owners who don’t participate in a corporation’s daily operations can be paid through dividends. However, owners who are active in corporate operations are considered employees and are paid through salary.

Someone hands over a paycheck to a businesswoman.

2. How Your Business Structure Affects Your Payment Method

Should I pay myself a salary or draw compensation from company funds? This depends on your business structure:

  • If you are a sole proprietor or the owner of a single-member LLC, you get paid through an owner’s draw.
  • If you are a C corporation owner active in company operations, you get paid a salary as an employee.
  • If you are a C corporation shareholder who isn’t active in company operations, you get paid through dividends.
  • If you are a partner in a partnership, a member of a multiple-member LLC or a shareholder in an S corporation, you get paid through distributive shares.

Each structure and method of payment has its own tax regulations, rates and reporting requirements. Because how you are paid and the amount you owe on taxes directly depends on your business structure, you should choose your structure accordingly when setting up your company.

If you have already set up your structure, you may wish to modify it to gain a tax advantage.

3. How Payments Affect Equity

Equity is an accounting term that refers to the value of your business. It represents how much a company’s owner or shareholders would receive if all the company’s assets were sold and all its debts were paid off. It can be calculated by taking your assets and subtracting your liabilities. This information gets recorded on your balance sheet.

Both owner’s draws and salaries affect your equity in different ways. An owner’s draw reduces your company’s assets, which lowers your equity. Salaries that haven’t yet been paid are classified as liabilities on your balance sheet, which can also lower your equity. Salaries that have been paid classify as expenses, which aren’t recorded directly on your balance sheet but are handled on your income statement (also called your profit and loss statement).

4. How Your Payment Method Affects Your Tax Liability

In general, sole proprietorships, single-member LLCs, partnerships and S corporations are classed together as flow-through entities (also called pass-through entities), meaning that profits pass from the company to the individual for tax purposes. In contrast, owners of C corporations must pay both corporate taxes on behalf of the company and individual taxes on compensation received from the company.

The best way to pay yourself from a corporation or other company structure depends largely on which structure and payment method would cost you the least in taxes. This in turn depends partly on your tax bracket.

Under the 2017 Tax Cuts and Jobs Act (TCJA), corporations pay a flat tax of 21%, while owners of companies using a pass-through structure can claim a 20% pass-through deduction on their personal tax filing. Under tax rates for households, rates of 22% and up apply for individuals earning $40,525 or more and for married couples filing jointly earning $81,050 or more.

These recent developments have made C corporations advantageous for some business owners in higher income brackets, while allowing business owners in lower brackets to take advantage of pass-through deductions. However, a number of factors can affect your tax liability, and there is no one-size-fits-all rule for which structure is best in a given situation.

Consult a financial professional who can help you crunch the numbers for your unique situation when choosing a business structure.

A paycheck that reads “My Salary” is surrounded by question marks.

5. How Much to Pay Yourself?

When deciding how much to pay yourself, several considerations come into play.

These include:

  • What constitutes reasonable compensation for your position
  • Your company’s financial condition
  • Your tax strategy

Reasonable Compensation

If you pay yourself through an owner’s draw, you can legally withdraw whatever percentage of your company’s funds you want (although this is not necessarily prudent from a financial perspective). But if you pay yourself a salary, the Internal Revenue Service (IRS) requires corporate employees to receive what is called “reasonable compensation.” This means that your salary is proportionate to your duties and experience and in keeping with what today’s market pays for the type of work you do.

You can run afoul of reasonable compensation requirements in a couple ways. If you receive an excessive salary, the IRS may question whether you’re trying to avoid corporate taxes. On the other hand, if you receive an excessively low salary, they may question whether you’re trying to avoid payroll taxes. Check current market rates and consider potential auditing issues when setting your salary.

Company Finances

Another consideration is your company’s financial state. Some business owners treat all revenue as their personal income, forgetting about their company’s operating expenses, debts and tax liabilities. This can create cash-flow problems.

When withdrawing company funds, draw from profits rather than revenue, after taking your company’s financial obligations into account. In addition, you may wish to consider reinvesting some of your profits in growing your company through marketing, in improvements to your facilities or equipment or in research and development.

Tax Strategy

Your tax strategy also figures into how much you pay yourself. Before deciding how much to withdraw or how much salary to pay yourself, consider how your decision will affect what you pay or deduct on items such as payroll taxes, retirement plans and health insurance.

An experienced tax professional can help you make a more informed decision.

6. How to Record Payments to Yourself for Bookkeeping

Keep your business and personal accounts and books separate. This will help keep you from getting business transactions mixed up with personal transactions, which can create confusion in bookkeeping and tax reporting and potentially lead to audits and legal trouble. You can keep your business and personal books separate by using separate files or by segregating personal transactions as a separate line-item category.

When making an owner’s draw, you should adjust your equity in your balance sheet. The amount you draw should be recorded as a debit in an account labeled something like “owner’s draw” and a credit in an account labeled “cash.”

When paying yourself a salary, you treat your salary as an expense. Debit your “expense” account and credit your “cash” account.

7. How to Report Payments to Yourself for Taxes

How you report your payments for taxes depends on whether you’re using an owner’s draw or a salary method.

How to Report Owner’s Draw on Taxes

When using an owner’s draw, you report your draw as income on your personal taxes. If you’re a sole proprietor or single-member LLC, you report it with your 1040 form by attaching a Schedule C.

For business structures using distributions, submit your 1040 form with a Schedule K-1 attachment. Dividends get reported as dividend income on a 1040.

How to Report Owner’s Salary on Taxes

Paying yourself a salary when self-employed gets reported as an expense deduction in your business taxes and as income in your personal taxes. On your personal taxes, you would report your salary as W-2 income on your 1040 form.

Pay Yourself Right So You Can Keep More of Your Profits

Knowing how to pay yourself as a business owner helps you optimize your tax strategy so that you get to keep more of what your company earns. The money you save is worth the extra investment in time and resources it may take to develop the right strategy.

Consider talking to a professional experienced with answering small business tax questions who can help you determine the best strategy for paying yourself. An experienced advisor can also help you decide which form of small business financing best complements your accounting and tax strategy.

Roy Rasmussen Contributing Writer for Fast Capital 360
Roy is a respected, published author on topics including business coaching, small business management and business automation as well as an expert business plan writer and strategist.
  Back to Top