As a small business owner, one of the most critical decisions you’ll make is how to pay yourself. It’s not just about deciding how much but also about choosing the right method that aligns with your business structure and tax obligations. Whether it’s through draws, guaranteed payments, salary, distributions, or dividends, understanding these options can help you manage your personal and business finances more effectively!

Paying Yourself as a Small Business Owner: Understanding Your Options

There are generally four ways to pay yourself as a small business owner.

1. Draws. Draws are the standard method for sole proprietors and partners in a partnership. It’s essentially withdrawing money from your business earnings for personal use. Draws are not subject to payroll taxes when taken. They don’t impact your tax obligations at year-end because you’re taxed on all business profits, regardless of whether you leave them in the business or take them as a draw.
2. Guaranteed payments. Particularly relevant for partnerships and multi-member LLCs, guaranteed payments are similar to a salary but without the payroll taxes. As the name implies, these payments ensure a partner or member gets a guaranteed minimum amount, even if the business makes little or no profit.
3. Salary. Paying yourself a salary is a straightforward approach, especially for owners of corporations. This method involves setting up a payroll, paying regular wages, and withholding taxes. It’s a must for S corporation owners who work in their business.
4. Distributions or dividends. Primarily for owners of S corporations and C corporations, distributions (S corps) or dividends (C corps) are payments made from the profits of the company.

Choosing the Right Method Based on Business Structure

Now, let’s review the options available to you for different business structures.

Sole Proprietorship

As a sole proprietor, you pay yourself with draws since you and your business are legally the same entity. Remember, these draws are not counted in your taxable income. Instead, you pay income and self-employment taxes on 100% of your business profits.

Also, draws aren’t deductible business expenses. Instead, they reduce your equity in the business.

Partnerships

In a partnership, each partner can take draws or receive guaranteed payments. The choice often depends on the partnership agreement and the business’s profitability.

Guaranteed payments should be outlined in your operating agreement. Unlike draws, guaranteed payments are deductible expenses for the business. However, they’re reported on your Schedule K-1 from the partnership and count as taxable income when you file your individual income tax return.

S Corporations

As an S corporation owner who works in the business, you must pay yourself a reasonable salary. You withhold income and payroll taxes from that salary, just as you would for any other employee of the business.

In addition to that salary, you can take compensation in the form of distributions. Distributions are similar to draws because they’re not deductible business expenses—they reduce your equity in the business.

The benefit of this business structure’s approach to owner compensation is that you only pay FICA taxes on your salary—not the distributions. Under the right circumstances, this can result in significant self-employment tax savings!

C Corporations

As a C corporation owner, you pay yourself a salary and/or dividends. Your salary is subject to income and payroll taxes, and dividends are taxed at a potentially lower rate.

However, be aware that C corporations are subject to “double taxation,” meaning the corporation pays taxes on profits and you, as a shareholder, pay taxes on those profits again when they’re distributed out as dividends.

C corp owners have an incentive to avoid double taxation by “zeroing out” the income of the corporation, paying officer salaries and bonuses that absorb all of the company’s profits. However, the IRS may scrutinize tax returns where it appears the corporation is paying excessive compensation to shareholders to avoid corporate taxes.

Limited Liability Company

Limited liability companies (LLCs) are unique because, for tax purposes, they can be treated like a sole proprietorship, partnership, S Corporation, or C Corporation.

If you have a single-member LLC, meaning you’re the only owner, you’re treated like a sole proprietorship for federal tax purposes and take your compensation in the form of draws.

LLCs with more than one owner are generally treated like partnerships and can take a combination of draws and guaranteed payments.

LLCs can also elect to be treated as S corporations or C corporations. If your LLC makes such an election, you’ll follow the owner compensation rules for that business structure.

Navigating Tax Implications and Compliance

Each payment method comes with its own tax implications and legal requirements, so it’s essential to:

• Understand how your chosen method affects your personal and business taxes
• Comply with IRS rules regarding reasonable compensation, especially for S and C corporations
• Keep meticulous records of all payments and their classifications

Deciding how to pay yourself as a small business owner is a balancing act between maximizing your income and minimizing tax liabilities, all while staying compliant with IRS regulations. Your business structure plays a pivotal role in determining the most beneficial method for you. It’s a good idea to consult a tax professional to navigate these choices effectively.

If you need help selecting a business structure, handling payroll, or finding the right balance between salary and draws, contact NewWay Accounting! Remember, your decision on how to pay yourself can have significant implications for both your personal and business finances, so choose wisely!