If you're like most small business owners, you started your business to run things the way you want and make your own decisions. But you don't have free rein to pay yourself whatever and however you want.
How and how much you pay yourself as a small business owner depends on a host of considerations, from your business entity to your business's finances and IRS rules.
Depending on their business entity, owners pay themselves by taking an owner's draw (a portion of profits) or by taking a salary.
Taking an owner's draw means withdrawing your pay from your business's net profit, which is the amount left over after you pay your expenses from your revenues.
Before dipping into your net profits, you should allocate a portion to reinvest in your business, and keep some funds as a cushion for unexpected expenses. After that, you can withdraw all or a portion of what's left of your profits to pay yourself. The amount will depend on your financial needs and wants.
You can arrange to draw your pay as you need it or on a fixed schedule, such as weekly or monthly; and you can vary the amount of each withdrawal based on your profits or your personal needs in that period.
Business owners who use this method must pay the IRS their estimated income and self-employment (Social Security and Medicare) taxes each quarter. The amount of tax you'll pay is based on a percentage of the income your business earned in that quarter, not a percentage of the owner's draw you took (more on how taxes are calculated below).
If you have ever been an employee, working for someone else, you'll recognize this method: Your business will pay you a fixed amount on a set schedule, such as weekly or monthly. Federal and state income taxes, and Social Security and Medicare taxes will be deducted from your paycheck.
Sole proprietorships can use only the owner's draw method, because the business and owner are one and the same under this business structure. The IRS doesn't consider sole proprietors to be employees, so they can't be paid a salary.
Partnerships also must pay themselves using an owner's draw (referred to as a distributive share when it's a partnership). Like sole proprietors, partners in this business structure aren't considered employees by the IRS and they can't receive a salary.
Partnership draws typically track the partners' ownership share in the business. For example, if two partners share equal ownership of the partnership, they equally distribute the profits as draws. However, partnerships have great flexibility in distributing their profits.
For example, one owner could get 75% of the profits and the other 25%, even though they are each equal owners of the partnership. Partnership profits can be distributed according to each owner's collection of revenue or receipts, shared equally, shared according to each owner's percentage of ownership, or based on a combination of methods—for example, draws could be based partly on ownership percentages and partly on collections.
Partners also have the option of being paid "guaranteed payments," also called partners' salary. These are treated the same as employee wages. They can be a set amount--for example, $1,000 each month--or based on the partnership's profits.
Limited liability company (LLC) members pay themselves according to the way they have chosen to be taxed.
By default, LLCs with one member (owner) are taxed like sole proprietorships. Accordingly, single member LLCs pay themselves using a draw. However, single member LLCs may elect to be taxed as S-Corporations by filing the necessary paperwork with the IRS. In this event, the member becomes an employee of the LLC and is paid a salary plus shareholder distributions (similar to an owner's draw).
Multiple member LLCs are taxed like partnerships by default, but they can also elect to be taxed as S-Corporations. In this event, they become employees of the LLC.
S-Corporation owners who are actively engaged in running or managing the business must be paid a salary. However, the IRS allows these owners to take shareholder distributions in addition to their employee salary. Such distributions are free of payroll tax.
C-Corporation owners actively engaged in running or managing the business are employees of the business and must also use the salary method for paying themselves. These owners, who are shareholders of their corporation, may also take shareholder dividends of the corporation's profits in addition to their salary. C-Corporation dividends are free of payroll tax, just like for an S-Corporation, but they are not a deductible expense for the C-Corporation. This means they get taxed twice--the corporation pays a 21% corporate tax on the profits and the shareholders pay tax on it at their personal tax rates--as high as 37%.
You should think about how you want to pay yourself when you choose how to legally organize your business. If you run your business as a sole proprietorship, partnership, or LLC (that files taxes as a sole proprietorship), you'll have to use an owner's draw. If you choose the corporation form, you must be paid an employee salary. You'll want to weigh the relative advantages and disadvantages of both methods, based on your business needs and the taxes you'll incur with each method.
The main advantage of an owner's draw is flexibility. You can adjust the amount of money that you take from your business, depending on your profits and your needs. This method is typically very helpful for startups with inconsistent cash flow. You won't be locked into taking a set amount of money out of your business when it can least afford the expense.
One disadvantage of using an owner's draw is your pay will likely fluctuate from one month or one quarter to the next, and you'll have to budget carefully to cover your personal expenses. You'll also have the responsibility of keeping careful records of the money you withdraw and paying your income taxes quarterly. The IRS requires you to pay taxes on your income as you earn it, and you can be penalized if you owe a large sum at the end of the year.
If you pay yourself an employee salary, you'll get a consistent income to cover your personal expenses, and your income taxes will automatically be deducted from your paycheck. You won't have to worry about making quarterly tax payments to the IRS.
However, if your business misses its targets for a given period, the fixed expense of a regular salary can eat into your cash flow and leave you unable to pay other expenses.
You can find information on the average salaries paid to those with the same or similar job responsibilities to yours (although not specifically for small business owners) on a number of websites including Payscale and the U.S. Bureau of Labor Statistics.
However, when you are the owner of the business, deciding how much to pay yourself isn't as simple as knowing what others with similar job responsibilities earn.
Some sole proprietors, partners, and LLC members (who file taxes as sole proprietorships) don't pay themselves anything when the company is a startup. Others simply don't generate enough profits to pay themselves what they're worth.
As a practical matter, you'll want to pay yourself enough to cover your personal expenses. If your personal expenses exceed the amount available from your business profits, you'll have to find a way to reduce your expenses or use savings or another source of income to cover your personal needs.
The IRS sets guidelines for paying both employees and owners of corporations, because under IRS rules, corporations may deduct salaries as a business expense. If the IRS determines that your salary is excessive, it might not allow the company to deduct it.
The amount you pay yourself as an owner-employee of a corporation must:
Some of the guidelines the IRS uses to determine a reasonable salary include:
The IRS uses many more guidelines to determine whether a salary is reasonable. It's a good idea to review all of them before setting your salary.
Sole proprietorships and partnerships must pay income and self-employment taxes on their business's net income, not on how much the owners pay themselves.
Nor do owners' draws count when calculating the business's net profits. Owners' draws can't be counted as a business expense. In fact, draws don't count at all when you are calculating your tax bill as a sole proprietor or partnership.
Example: Let's say you are a sole proprietor whose business revenues for the year total $60,000. After deducting business expenses like rent, utilities, and supplies, your business earned $50,000. You've determined that your federal income tax rate is 10%. (Tax rates vary for each individual, based on their taxable income. Taxable income depends on numerous factors like whether you take the standard deduction or itemize your deductible personal expenses such as mortgage interest, property tax, and charitable contributions. A tax professional can help you determine your taxable income.)
In this example, the business owner would pay 10% of $50,000 or $5,000 in income taxes, regardless of how much they paid themself. (A partnership works the same way except each partner pays taxes based upon their distributions.) The owner also must pay self-employment taxes (Social Security and Medicare taxes) on net self-employment income--a combined 15.3% tax.
It doesn't matter whether the owner takes $5, $5,000, or any amount in draws. The owner's draws don't reduce your tax bill, and you'll still pay $5,000 in income taxes plus $7,650 in self-employment tax.
Another thing to keep in mind is that sole proprietorships, partnerships, almost all LLCs, and S-Corporations are "pass-through entities" for tax purposes. They pay no taxes themselves. Instead, all the profits they earn pass through the business and are taxed on their owner's personal tax returns at their personal income tax rate, not the corporate tax rate. C-Corporations are separate entities for tax purposes with their own corporate tax rate, which is a flat 21%.
Single member LLCs that don't elect to be taxed as corporations pay taxes the same way as the sole proprietor described above. When an LLC has more than one member, each member pays taxes based on partnership draws plus any guaranteed payments.
If you are an owner-employee of an S-Corporation or a C-Corporation, you'll pay income taxes on the salary you received from the business. However, the business can deduct your salary and the portion of Social Security and Medicare taxes it pays on your salary from its taxes.