Can You Use a Business Loan to Pay Yourself?

Using a business loan to pay yourself is a common consideration for many entrepreneurs. The ability to do so, however, depends on your lender’s rules, your business’s legal structure, and specific tax regulations.

Understanding Your Loan Agreement’s Terms

Before using any loan funds for personal compensation, the first action is to thoroughly review your loan agreement. This document dictates how the borrowed funds can be used, and you will find a section often titled “Use of Proceeds” or “Use of Funds” that outlines the approved purposes.

Some loan agreements may broadly permit funds to be used for “working capital,” a category that can include salaries and owner compensation. Other agreements might be more restrictive, listing specific prohibited uses, such as using loan proceeds to repay or reimburse funds owed to an owner. Scrutinizing this section will reveal whether paying yourself is expressly allowed, implicitly permitted, or forbidden entirely.

Beyond the “Use of Proceeds” clause, look for other covenants or conditions. Lenders may include negative covenants that restrict certain financial activities or affirmative covenants that require you to maintain specific financial ratios. A large or improperly documented payment to yourself could violate these terms, leading to a default on the loan.

Payment Methods by Business Structure

The method for paying yourself with loan proceeds is dictated by your company’s legal structure. Each formation has a specific procedure for owner compensation, which is necessary for compliance with your lender and tax authorities.

Sole Proprietorships and Single-Member LLCs

For a sole proprietorship or a single-member LLC taxed as a sole proprietorship, the owner is not considered an employee and cannot take a formal salary. Instead, compensation is taken as an “owner’s draw” by transferring funds from the business bank account to your personal account. There are no payroll tax withholdings on a draw at the time of the transfer.

An owner’s draw represents a withdrawal of the company’s profits. Since the IRS considers a sole proprietor and their business to be a single entity for tax purposes, all business profits are already considered your personal income. The draw is simply the act of moving that money for personal use and is an accounting transaction that reduces the owner’s equity in the business.

Partnerships

In a partnership or a multi-member LLC taxed as a partnership, partners are also not employees and cannot receive a W-2 salary. Similar to sole proprietors, partners take compensation through draws, which are distributions of the partnership’s profits. The amount and frequency of draws are governed by the partnership agreement.

Alternatively, a partnership can provide “guaranteed payments” to partners for services rendered or for the use of capital, without regard to the partnership’s income. Unlike draws, guaranteed payments are treated as a business expense for the partnership, which reduces its ordinary income. The partner receiving the payment reports it as self-employment income.

S-Corporations

S-Corporations have specific rules regarding owner compensation that differ significantly from other structures. If you are a shareholder who actively works for the business, the IRS requires that you be paid a “reasonable salary” as an employee. This means you must be placed on the company payroll, receive a Form W-2, and have payroll taxes withheld from your paycheck.

Reasonable compensation is based on what similar enterprises would pay for comparable services. Factors influencing this amount include:

• Your duties and experience
• Your time commitment to the business
• What non-shareholder employees are paid for similar work
• The complexity of the services performed

After paying yourself a reasonable salary, any remaining profits can be given to shareholders as distributions, which are not subject to self-employment or payroll taxes.

C-Corporations

Owners of C-Corporations who work in the business are considered employees and must be paid a reasonable salary for the services performed. The salary is a deductible business expense for the corporation, and the owner-employee pays personal income and FICA taxes on these wages.

Unlike S-Corps, C-Corps are subject to double taxation where the corporation pays taxes on its net profits, and shareholders pay taxes again on any dividends they receive. Paying a salary to an owner-employee is a way to extract earnings from the corporation while only being taxed once at the individual level, as the salary is deducted from the corporation’s taxable income.

Required Documentation and Tax Obligations

Properly documenting payments to yourself and meeting the associated tax obligations is as important as using the correct payment method. The requirements vary depending on whether you receive a salary or a draw, and failure to maintain accurate records can create problems with your lender and the IRS.

For owners receiving a salary from an S-Corp or C-Corp, the business must adhere to formal payroll processes. This involves issuing regular pay stubs that detail gross pay, withholdings, and net pay. The corporation is responsible for withholding federal and state income taxes, as well as FICA taxes for Social Security and Medicare. The employer pays half of the FICA taxes, and the employee pays the other half, with the total amount remitted to the IRS using Form 941.

Owner’s draws for sole proprietors and partners do not involve tax withholding at the time of payment. A draw is not a business expense; it is recorded in the company’s accounting ledger as a reduction of owner’s equity. The owner is responsible for paying self-employment tax on the business’s total net earnings for the year. This tax is calculated on Schedule SE (Form 1040) and consists of a 12.4% Social Security tax up to an annual earnings limit and a 2.9% Medicare tax on all net earnings. Owners taking draws should make estimated tax payments to the IRS throughout the year.

A 0.9% Additional Medicare Tax also applies to earnings that exceed certain thresholds: $250,000 for married couples filing jointly, $200,000 for single filers, and $125,000 for those married filing separately. This tax affects high-earning individuals, whether they are salaried owner-employees or self-employed.

Rules for Government-Backed Loans

When your financing comes from a government-backed program, such as a loan guaranteed by the Small Business Administration (SBA), you must follow an additional layer of specific regulations. These loans often have stricter guidelines on the use of proceeds compared to conventional bank loans.

The SBA 7(a) loan program allows proceeds to be used for working capital, which can include owner salaries. However, the SBA and the lender will expect any compensation to be reasonable and well-documented. The loan agreement will also prohibit certain uses, such as reimbursing an owner for a prior equity injection.

Programs like the Economic Injury Disaster Loan (EIDL) have historically had very precise rules regarding compensation, often limiting it to levels established before the disaster event. Because regulations for government loan programs can be detailed and are subject to change, borrowers must always refer to the official guidance and their specific loan agreement. Misusing funds from a government-backed loan can lead to severe consequences, including immediate repayment demands and potential legal action.