From SCORE: How do I pay myself as a small business owner?

High on your priority list as a business owner is getting a financial benefit from all your hard work. So, one of the first and most pressing questions you’ll ask yourself is: “How do I pay myself?”

The answer isn’t necessarily obvious because it’s not the same for every business. How you go about it depends on a few factors, most prominently the structure of your business. Learning about the various methods of self-payment early on will help you grow your venture with consistency and confidence.

Methods of paying yourself

Salaries, owner’s draws, distributions and dividends are the primary ways that business owners pay themselves. Which you choose depends largely on your business’ structure and will have tax implications.

Salary

Giving yourself a regular salary, just as you would an employee, is a way of providing yourself a consistent income stream and predictability for your business’ budget. When you pay yourself a salary, you must withhold taxes for the IRS from each paycheck—best done via accounting software or a professional bookkeeper.

Doing things this way is a legal requirement if your business is structured as an S Corporation, C Corporation or limited liability company (LLC) that is taxed as a corporation. The IRS has rules for setting your salary — called “reasonable compensation” regulations — to prevent you from taking an unreasonably large amount or trying to avoid taxes by paying yourself too little.

Owner’s draw

An owner’s draw is the only option available to sole proprietors and LLCs, allowing you to take compensation from your business’ profits on an as-needed basis. You can draw out as much of the business’ money as you own, an amount called the owner’s equity. You cannot draw any money that your business owes to an investor, lender or employees (liabilities). Owners of S and C Corps cannot take draws.

Paying yourself by owner’s draw lacks the formality of paying yourself a salary; you don’t have to deduct and submit taxes every time you pay yourself. However, it is still a good idea to set aside the money you’ll need for personal income taxes as you go, so you’ll be ready to pay the right amount of estimated taxes throughout the year.

Distributions and dividends

S and C Corps can pay a portion of their profits to shareholders via distributions and dividends. Dividends are commonly made by C Corps and come in the form of cash payments or additional shares. Distributions always come from S Corps (or mutual funds) and are always paid as cash. Business owners who take a reasonable salary can also get distributions and dividends.

Dividends are taxed twice — at both the corporate and individual levels. Distributions are taxed once — as corporate earnings on each shareholder’s individual tax return, not as income.

How much to pay yourself

The salary you pay yourself must follow the IRS’s “reasonable compensation” requirement, which states that your salary must compare with what someone doing your work within your industry would typically be paid as an employee.

Those taking owner’s draws can pay themselves as much as the business’ net profit; that means you can take all of the business’ income that isn’t a liability or operational expense. The goal is to meet all your business’ obligations before paying yourself. One way of doing this is to set your draw as a percentage of profits so your compensation fluctuates with the success of the company each month.

The complex nature of distributions and dividends makes it advisable to consult an accountant about how to handle these payments. 

Start simple, then reevaluate

Most small business owners who are just starting out are sole proprietors — that’s the default IRS status. You can elect to be a single-member LLC very easily to gain a bit of legal protection, but your tax status will be identical to that of a sole proprietor. Considering that those with this tax status are only legally allowed to pay themselves by owner’s draw, the decision is made for you when you’re a fledgling business owner.

It’s only after your business starts to grow that you’ll need to consider whether a different arrangement might be necessary or advantageous. At a certain point, you should consult with an accountant to discuss the question of how you’re paying yourself — among many others — to ensure that your business is tax-compliant and primed to grow.

Have more questions? Reach out to SCORE for free, expert mentoring and resources to guide you through your small business journey. Visit score.org/stlouis to learn more.