What Percentage of Profits Should I Pay Myself?

Determining the appropriate level of compensation for a business owner is a nuanced decision with lasting implications for both the individual and the business. This process involves a careful assessment of financial health, strategic objectives, and various other considerations. Understanding how to approach this decision can help business owners establish a sustainable financial foundation for their enterprise while also meeting personal financial needs. This article provides guidance on navigating the complexities of owner compensation, ensuring that decisions align with long-term business viability and personal financial well-being.

Understanding Business Profit

To determine how much profit to pay oneself, a business owner must first clearly understand the various definitions of profit. Profit represents the financial gain remaining after all expenses are subtracted from revenue. This concept is broken down into gross profit and net profit, each offering a distinct perspective on a business’s financial performance.

Gross profit is the revenue generated from sales minus the direct costs associated with producing goods or delivering services, often referred to as the Cost of Goods Sold (COGS). These direct costs include raw materials, direct labor, and manufacturing overhead directly tied to production. This initial profit figure indicates how efficiently a business converts its sales into earnings before considering broader operational expenses.

Net profit, also known as the bottom line, is a more comprehensive measure. It is calculated by subtracting all business expenses from total revenue, including COGS, operating expenses, interest, and taxes. Operating expenses encompass a wide range of costs not directly tied to production, such as administrative salaries, rent, utilities, marketing, and insurance. This final figure represents the actual amount of money a business keeps after all obligations are met, making it the primary indicator of overall financial health and the pool from which owner compensation is typically drawn. Businesses usually pay taxes on their net profit.

Factors Influencing Owner Compensation

Deciding on owner compensation involves evaluating the business’s financial health, future aspirations, and the owner’s personal financial requirements. A primary consideration is the business’s current cash flow, which dictates immediate fund availability. Healthy cash flow ensures the business covers operational expenses, payroll, and other liabilities before owner distributions. Maintaining sufficient operating reserves, typically three to six months of expenses, is important for unexpected challenges.

Reinvestment for business growth also influences the profit available for owner compensation. Channeling earnings back into the business can fund expansion, product diversification, and marketing initiatives. Investing in technology upgrades, employee development, or improved inventory management enhances efficiency and productivity. Strategic reinvestment ensures long-term sustainability and competitiveness, potentially leading to greater future profits.

The owner’s personal financial needs and goals also play a role. These include covering living expenses, building personal savings, and planning for retirement. Balancing personal financial security with business needs requires careful planning to avoid overdrawing funds that could support operations or growth. Owners might set a personal budget to understand their minimum income requirements.

The business’s legal structure influences the type of compensation an owner receives. A sole proprietorship or Limited Liability Company (LLC) typically allows owners to take an “owner’s draw.” S Corporations and C Corporations generally require owners who provide services to receive a “salary.” The chosen structure dictates payment mechanics.

Industry benchmarks offer a general guide, providing insight into what other businesses in a similar sector pay their owners. While no universal “best” percentage exists, understanding industry norms can help validate compensation decisions. These benchmarks should be adapted to the specific financial condition and growth stage of the individual business. Ultimately, the decision balances immediate personal needs with the long-term financial health and growth potential of the business.

Methods of Paying Yourself

The practical methods for a business owner to extract money from their business largely depend on the legal structure of the entity. Each method has distinct operational procedures.

For sole proprietorships and Limited Liability Companies (LLCs) taxed as pass-through entities, the common method is an “owner’s draw” or “owner’s distribution.” This involves simply transferring funds directly from the business bank account to the owner’s personal account. There are no formal payroll processes. Owners can take draws as frequently as cash flow allows, though it is often done on a regular schedule or as needed.

S Corporations and C Corporations require owners who actively work in the business to be paid a “salary.” This salary is subject to regular payroll, just like any other employee’s wages. The business must set up a payroll system, withhold applicable amounts, and remit them to the appropriate tax authorities, usually on a bi-weekly or monthly basis. The Internal Revenue Service (IRS) requires that this salary be “reasonable compensation” for the services rendered, meaning it should be comparable to what someone in a similar role within the industry would earn.

Beyond a salary, S Corporation owners can also receive “distributions” of the company’s profits. These distributions are typically taken after the owner’s reasonable salary has been paid. For LLCs taxed as S Corporations, distributions work similarly to an owner’s draw. Funds are transferred from the business to the owner’s personal account.

C Corporations can distribute profits to shareholders, including owner-shareholders, through “dividends.” Dividends are paid from the corporation’s after-tax earnings. The payment of dividends is typically less frequent, often on a quarterly or annual basis, and is formally declared by the company’s board of directors.

Tax Considerations for Owner Compensation

The method by which a business owner pays themselves carries distinct tax implications that affect their overall tax liability.

For sole proprietors and owners of single-member LLCs, compensation taken as an owner’s draw is subject to self-employment tax. This tax covers Social Security and Medicare contributions, similar to FICA taxes paid by employees and employers. The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security and 2.9% for Medicare. For 2025, the Social Security portion applies to net earnings up to $176,100, while the Medicare portion applies to all net earnings. Owners typically calculate this tax on 92.35% of their net earnings from self-employment and can deduct one-half of their self-employment tax from their gross income. These earnings are reported on Schedule C of Form 1040.

For S Corporation owner-employees, the salary component is subject to federal income tax withholding and FICA taxes, split between the employee and the corporation. For 2025, the Social Security tax rate is 6.2% for both the employer and employee (12.4% total) on wages up to $176,100. The Medicare tax rate is 1.45% for both (2.9% total) on all wages. An additional Medicare tax of 0.9% may apply to wages exceeding certain thresholds, such as $200,000 for single filers, with no employer match. Distributions from an S Corporation, taken after the reasonable salary, are generally not subject to self-employment tax or additional FICA taxes, as the business’s income has already passed through to the owner’s personal tax return. These distributions are tax-free to the extent of the shareholder’s basis in the company; distributions exceeding basis are taxed as capital gains.

C Corporations present a different tax structure, notably “double taxation.” The corporation first pays corporate income tax on its profits, with the federal corporate tax rate currently at 21%. When these after-tax profits are distributed to shareholders as dividends, those dividends are taxed again at the individual shareholder level. Qualified dividends often receive preferential tax treatment, taxed at long-term capital gains rates (0%, 15%, or 20%), depending on the shareholder’s income bracket. Ordinary dividends are taxed at the individual’s regular income tax rate, which can range from 10% to 37%. Salaries paid to owner-employees by a C Corporation are deductible business expenses for the corporation, reducing its taxable income, but are subject to payroll taxes for the employee.