Paying Yourself As A Business Owner

For small business owners, one of the most pressing, and often confusing, aspects of running their venture is determining how to pay themselves. Unlike employees who receive a consistent paycheck, business owners must navigate a complex landscape of legal structures, tax implications, and cash flow considerations.

Understanding the different methods of owner compensation, including salary, owner’s draw, and dividends, is crucial for financial stability and business growth. This choice not only impacts personal income but also influences the company's tax obligations and overall profitability. The Internal Revenue Service (IRS) has specific guidelines for each payment method, making informed decisions essential for compliance and minimizing tax burdens.

Understanding the Landscape

The 'how' of paying yourself depends heavily on your business structure. Sole proprietorships and partnerships typically use owner's draws. Corporations, especially S corporations, often opt for a reasonable salary in addition to potential distributions.

An owner's draw allows the owner to take cash from the business's profits, subject to self-employment taxes. A salary, on the other hand, is treated like employee income, with payroll taxes and withholding.

Sole Proprietorships and Partnerships: The Owner's Draw

In a sole proprietorship or partnership, the owner and the business are essentially considered one entity for tax purposes. Owners do not receive a salary, but rather take an owner's draw from the business profits. This draw is not subject to payroll taxes, but the profits of the business are subject to self-employment taxes, which cover Social Security and Medicare.

The amount of the draw is usually determined by the business's profitability and the owner's needs. However, it’s crucial to keep accurate records of all draws and report them properly on your tax return. Remember to set aside funds for quarterly estimated taxes, as self-employment taxes are not automatically withheld.

S Corporations: Salary and Distributions

S corporations offer a more structured approach to owner compensation. As an employee of the S corporation, the owner must pay themselves a "reasonable salary" for the services they provide. This salary is subject to payroll taxes, similar to any other employee.

In addition to a salary, S corporation owners can also receive distributions of profits. These distributions are not subject to self-employment taxes, making them a tax-efficient way to access business earnings, provided the salary is deemed “reasonable” by the IRS.

The IRS closely scrutinizes S corporation owner compensation to ensure that owners are not avoiding payroll taxes by taking excessive distributions and minimizing their salary. A "reasonable salary" is defined as the amount that a similar employee in a similar role would receive at a comparable company.

C Corporations: Salary and Dividends

C corporations offer two main avenues for owner compensation: salary and dividends. As with S corporations, owners who work for the business can receive a salary subject to payroll taxes.

C corporations can also distribute profits to shareholders in the form of dividends. However, dividends are subject to double taxation: once at the corporate level and again at the individual shareholder level. This double taxation is a major disadvantage of the C corporation structure for many small business owners.

Planning and Consistency

Regardless of the payment method, consistent and careful planning is essential. Develop a budget that includes your personal financial needs and the business's operating expenses.

Regularly review your compensation strategy with a qualified accountant or financial advisor. They can help you determine the most tax-efficient and financially sound approach for your specific situation.

The Small Business Administration (SBA) offers resources and guidance on financial management for small business owners. Utilizing these resources can provide valuable insights and support in navigating the complexities of owner compensation.

Ultimately, paying yourself is not just about taking money out of the business. It's about strategic planning, tax compliance, and ensuring the long-term financial health of both you and your company. By understanding the available options and seeking professional guidance, business owners can create a compensation strategy that supports their personal well-being and the sustainable growth of their ventures.