Can You Pay Yourself With a Business Loan?

Using a business loan to pay yourself is a common consideration for entrepreneurs. While generally possible, it’s not a simple transaction. The ability to use loan proceeds for owner compensation depends on the loan agreement’s terms, the business’s legal structure, and the stated purpose of the funds. Lenders have precise rules about how borrowed money can be used, and owner compensation requires careful navigation to ensure compliance.

Understanding Permissible Loan Uses

Business loans are intended to support a company’s operations and growth. Funds are often designated for “working capital,” which covers day-to-day operational expenses like inventory, rent, utilities, and marketing. Working capital also includes payroll costs, which can encompass compensation for the business owner if it is structured correctly and is reasonable for the services performed.

Lenders distinguish between legitimate business expenses and personal ones. Using a loan for a down payment on a personal residence, paying off individual credit card debt, or making personal investments is forbidden by nearly all business loan agreements. Misusing funds can trigger severe penalties, including immediate loan default. Any owner compensation must be treated as a formal business obligation.

How Business Structure Affects Owner Payments

The method for paying an owner with loan proceeds is dictated by the company’s legal structure. Each entity type has a different mechanism for distributing money to its owners, affecting how compensation is handled for accounting and tax purposes.

Sole Proprietorships and Single-Member LLCs

For a sole proprietorship or a single-member LLC, the owner and business are the same for tax purposes. Owners in this structure do not receive a salary but instead take an “owner’s draw,” which is a withdrawal of funds for personal use. This is not a business expense but a reduction of the owner’s equity. When using loan funds, the money is deposited into the business bank account, and the owner can then execute a draw.

Partnerships and Multi-Member LLCs

In partnerships and most multi-member LLCs, owners usually do not receive a W-2 salary. Instead, they may receive “guaranteed payments” or take draws. Guaranteed payments are for services or capital use and are treated as a business expense. Draws are distributions of profit that reduce a partner’s capital account. The partnership agreement governs how partners are compensated, and payments from loan proceeds must align with these terms.

S Corporations

The IRS mandates that any S corporation shareholder who provides significant services to the business must be paid a “reasonable salary” as a W-2 employee. This salary is subject to payroll taxes, including Social Security and Medicare (FICA). This rule prevents owners from avoiding payroll taxes by taking all compensation as distributions. When using a loan for working capital, a portion can be allocated to the owner’s formal salary and processed through a payroll system.

C Corporations

Owners of a C corporation who work in the business are treated as employees and must be paid a reasonable salary. This compensation is a deductible business expense and is subject to all applicable payroll taxes. The salary must be reasonable for the services provided to avoid IRS scrutiny, which could reclassify an excessive salary as a non-deductible dividend. Loan proceeds for working capital can fund these owner-employee salaries through the company’s payroll process.

Loan Agreement and Program-Specific Rules

Beyond business structure rules, the loan agreement governs how funds may be used. Every commercial loan includes a “use of proceeds” clause detailing permissible and prohibited expenditures. You must review this section before using funds for compensation, as a violation can lead to technical default and require immediate repayment of the entire loan.

Different loan types have varying levels of flexibility. While conventional bank loans may offer more discretion, the lender will still expect funds to be used for purposes outlined in the application. Government-backed loans, such as those from the Small Business Administration (SBA), have more stringent regulations. For example, SBA 7(a) loans allow proceeds to be used for working capital, including owner compensation, but it must be justifiable and align with the business plan submitted with the application.

Documentation and Accounting for Owner Payments

Properly documenting owner payments from loan proceeds is necessary for compliance and financial transparency with lenders and the IRS. The first step is to maintain separate bank accounts for business and personal finances. Commingling funds makes it difficult to prove that loan proceeds were used for legitimate business expenses.

For S and C corporations that pay owner salaries, formal payroll records are required. This includes running payroll regularly, withholding taxes, and making employer FICA contributions. Necessary documentation includes pay stubs, payroll summaries, and quarterly filings of IRS Form 941. A C corporation may need a board resolution to formally approve a significant salary to support its reasonableness.

For owner’s draws in sole proprietorships and partnerships, every transaction must be recorded in the business’s accounting system. A draw should be recorded as a debit to the owner’s draw account and a credit to the cash account. This entry creates a clear record that the transfer was a distribution of equity, not a business expense. This distinction is important for accurately reflecting the company’s financial health and for year-end tax preparation.