How to Pay Yourself From Your Business

Many business owners grapple with how to properly compensate themselves, a decision that carries significant tax and compliance implications. The method of payment is not uniform across all businesses; it fundamentally depends on the legal structure chosen for the enterprise. Understanding these distinctions is important for managing personal finances and ensuring adherence to tax regulations. Maintaining clear separation between business and personal funds is essential.

Paying Yourself as a Sole Proprietor or Partner

Sole proprietors and partners compensate themselves through “owner’s draws” or, for partners, “guaranteed payments.” An owner’s draw involves directly withdrawing funds from the business for personal expenses, not considered a salary or wage for tax purposes. These draws reduce the owner’s equity in the business. They do not appear on the business’s income statement as a deductible expense.

The tax implications for these payment methods center on pass-through taxation. The business itself does not pay income tax; instead, the owner’s share of business profits, whether distributed as a draw or retained, is subject to personal income tax. Additionally, these profits are subject to self-employment tax. This tax covers Social Security and Medicare contributions.

Since no taxes are withheld from owner’s draws or guaranteed payments, sole proprietors and partners are required to make estimated tax payments throughout the year. These quarterly payments cover both income tax and self-employment tax liabilities. Failure to make sufficient estimated payments can result in penalties. Administratively, draws are straightforward, avoiding formal payroll setup. However, meticulous record-keeping and separate business and personal bank accounts are necessary.

Paying Yourself from a Limited Liability Company (LLC)

An LLC offers flexibility in how its owners can be compensated, as its payment methods are dictated by its chosen tax classification. By default, a single-member LLC is taxed as a sole proprietorship, where the owner reports business income and expenses on Schedule C. Multi-member LLCs are taxed as partnerships, requiring Form 1065 and Schedule K-1 for each member’s individual tax return. In both default scenarios, owners use draws, and profits are subject to self-employment and personal income tax, requiring estimated payments.

An LLC can elect to be taxed as an S corporation by filing Form 2553, which alters how owners are paid. In this structure, an owner who actively works for the business must receive a “reasonable salary” subject to federal income tax withholding and payroll taxes (Social Security and Medicare). Any remaining profits can then be distributed to the owner as tax-free distributions, not subject to self-employment tax.

Alternatively, an LLC can elect to be taxed as a C corporation by filing Form 8832. Under this election, the owner who works for the business takes a salary, which is a deductible expense for the corporation and is subject to payroll taxes and income tax withholding. Any additional payments taken as dividends would be subject to double taxation, where the corporation pays tax on its profits, and then shareholders pay tax again on the dividends received. The administrative requirements for an LLC depend heavily on its tax election, ranging from simple owner’s draws for default classifications to formal payroll procedures for S or C corporation elections.

Paying Yourself from an S Corporation

S corporations provide a method for owners to receive compensation, primarily through a combination of salary and distributions. Owners who actively work for the business are required to pay themselves a “reasonable salary” for the services performed. This salary is treated like any other employee’s wages, subject to federal income tax withholding and payroll taxes (Social Security and Medicare). Both the employee (owner) and the S corporation contribute to these payroll taxes.

After paying a reasonable salary, any remaining profits can be taken as “distributions” or “dividends.” A key tax advantage of the S corporation structure is that these distributions are generally not subject to self-employment tax. This contrasts with sole proprietorships and partnerships, where all business profits are subject to self-employment tax. The Internal Revenue Service (IRS) scrutinizes the “reasonable compensation” requirement to prevent owners from classifying an unreasonably low salary to minimize payroll taxes. Factors considered for reasonableness include the owner’s experience, duties, responsibilities, and prevailing compensation for similar positions in the industry.

Administratively, S corporations must establish formal payroll systems, issue W-2 forms to owner-employees, and make regular payroll tax deposits to the IRS. Quarterly employment tax returns, such as Form 941, must be filed, along with annual federal unemployment tax returns (Form 940). Accurate record-keeping is essential for compliance and proper tax reporting.

Paying Yourself from a C Corporation

A C corporation is recognized as a separate legal and tax-paying entity distinct from its owners. Owners who work for the corporation are paid a salary, similar to any other employee. This salary is a tax-deductible expense for the corporation, reducing its taxable income. The salary is also subject to federal income tax withholding and payroll taxes (Social Security and Medicare).

A defining characteristic of C corporations is “double taxation.” This means the corporation’s profits are taxed at the corporate level. If any remaining after-tax profits are then distributed to shareholders as dividends, those dividends are taxed again at the individual shareholder level as personal income. Qualified dividends, however, may receive favorable tax treatment, often taxed at lower capital gains rates depending on the shareholder’s income bracket.

C corporation owners can also receive certain benefits, such as health insurance or retirement plan contributions, which can be tax-deductible expenses for the corporation. These benefits can provide additional forms of compensation beyond direct salary. Strict administrative requirements are in place for C corporations, including formal payroll processing, issuing W-2 forms, and making timely payroll tax deposits. Meticulous record-keeping is essential for all financial transactions, including salaries and dividends, often requiring formal corporate resolutions.