Salary vs. owner’s draw at a glance
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Salary, draws, and the IRS
As you can see above, your business entity type can play a major role in how you can pay yourself. Here’s a closer look at the implications of using different entity types.
Sole proprietor
Using draws is the only option for sole proprietors — you cannot legally pay yourself a W-2 salary. That’s because paying yourself a salary isn’t a deductible expense for tax purposes when you’re a sole proprietor. The IRS considers any payments you make to yourself a draw (and on the flipside, it considers any profits your business makes to be your personal income).
The good news is you won’t immediately have to pay tax on your draws. The bad news is these draws won’t reduce your taxable income like a salary would.
Here’s a quick example: Your customers buy $100,000 worth of products from you over the course of a year. Say your business expenses for the year are $60,000 and you’ve taken draws of $30,000.
At the end of the year, your taxable income would be $40,000 — the profits from the business, which your draws won’t reduce.
The IRS will tax this $40,000 (not the $30,000 you “drew”) as self-employment income so you’ll pay 15.3% tax for FICA. However, you will be able to take a deduction for half of the FICA tax you pay. And, then you will also pay income tax on that $40,000.
Partnership
Much like sole proprietors, partners in a partnership must use the draw method to pay themselves. The IRS doesn’t consider partners employees of a partnership. Therefore, you are unable to pay yourself a salary. You will be taxed like a sole proprietor for your percentage of the partnership’s income.
Limited Liability Company (LLC)
If you are a single-member LLC (meaning, you are the only owner), the IRS will consider the LLC a “disregarded entity” and treat your business as if you were a sole proprietor. You’ll have the same taxation concerns as a sole proprietor.
However, the IRS allows you to choose how you want to be taxed by filingForm 8832. You can elect to be taxed as a partnership or S-corp. Note: the default taxation classification is sole proprietor unless you inform the IRS you would like to be taxed as an S-corporation with Form 8832.
For multi-member LLCs, the IRS default taxation classification is as a partnership. You’ll have the same taxation concerns as partnerships, as discussed above. You can file Form 8832 to elect taxation as an S-corp, only if all members agree.
Related reading
Learn more about what Form 8832 is and the steps a business takes to change its classification for federal tax purposes.
S-corporation (S-corp or small corporation)
If your business is an S-corp, you must pay yourself a salary if you are actively involved in running and managing your business.
To keep you from avoiding employment taxes, the IRS requires S-corp owners to pay themselves a “reasonable salary” that is in line with their job duties, education, skills, and experience. There are services and websites available that will determine reasonable compensationfor you. But you can also look at what other companies pay their officers to get an idea of what is reasonable.
You can also take draws as an owner of an S-corp. However, you can’t take draws in lieu of a reasonable salary.
The good news is that your salary and the 7.65% of FICA tax the S-corp pays on your salary is tax deductible and will reduce the company’s taxable income. Also, any business profits that aren’t paid out as salary or an owner’s draw will be taxed at the corporate tax rate (instead of the personal income tax rate for sole proprietors and partnerships), which is often lower than the owner’s personal income tax rate.
C-corporation
Much like an S-corp, C-corp business owners who are actively involved in the business must be paid reasonable compensation. The good news is that, like an S-corp, your salary and the company portion of FICA tax is tax deductible.
The major difference from an S-corp is that a C-corp usually should not allow owners to take draws. Since the C-corp is typically owned by shareholders, the earnings of the C-corp are “owned” by the company.
If a C-corp business owner wants to “draw” money, above his or her salary, it must be taken as a dividend payment. The bad news is that the dividend payment is not a tax-deductible expense. If you want to take a draw from a C-corp, the better option may be to take it in the form of a bonus. A bonus would be a tax-deductible business expense for your business, and on your personal taxes, you may qualify for aflat bonus tax rate, which could be lower than your personal income tax rate.
Also, be careful to not pay yourself unreasonably high compensation. The IRS has taken the position that excessive compensation is a “disguised” distribution of company profits. In turn, these “disguised” distributions are really dividends in the eyes of the IRS and lose their tax-deductibility.
Simple and seamless
I love OnPay because it has a user-friendly interface where other payroll services can sometimes be confusing for a small business owner to understand and use effectively. OnPay also integrates with Quickbooks online seamlessly, which saves me a ton of time from manually inputting payroll reports.
— Alyssa Johnson, Electric Regatta LLC
How to determine reasonable compensation
After you settle on the best approach to paying yourself, the lingering question to answer is what exactly constitutes “reasonable compensation” in the IRS’ eyes? After all, the guidance from the government tax authority is that the pay should be reasonable.
But that doesn’t really tell you how much you should pay yourself as a business owner. The good news is that the IRS has issued some clarification on this front over the years. The agency defines “reasonable” on its website as follows:
“Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circ*mstances. Reasonableness is determined based on all the facts and circ*mstances.”
Yet another IRS website page dedicated to the topic suggests that public libraries may have reference sources that outline the average compensation paid for various types of services. You can also easily conduct research online for such salary or pay guidance, using platforms such as Glassdoor, Payscale, and Salary.com. In addition, the U.S. Bureau of Labor and Statistics website maintains a database of salaries by occupation and industry that can be a helpful guide.
Some additional considerations to keep in mind when establishing a reasonable pay include your level of education, your total years of work experience, and the cost of living in your region. You might also base your salary on your personal expenses or pay yourself a percentage of your profits.
Be careful with loans!
Steer clear of classifying any money you draw as a loan. Loans to owners must have terms like those required in traditional lending arrangements. That means there must be a signed promissory note, with stated reasonable interest rate, and a repayment schedule. There must also be consequences for non-payment. Otherwise, you risk the IRS reclassifying these “loans” to dividends or salary.
Plan ahead for taxes
The U.S. income tax system is a pay-as-you-go system and you are expected to pay taxes as you earn your revenue. If you’re using the draw method, you’ll need to set aside enough money to pay your tax bill. This may require you to make estimated quarterly payments to the IRS: If you owe more than $1,000 on April 15,you’ll be penalized.
As a small business owner, there’s lots of terminology to keep track of. It’s the reason why we compiled a glossary with many common payroll terms you’re likely to hear in the course of running your business.
The takeaway
Deciding how to pay yourself as a small business owner is an important consideration, one that can have tax ramifications for your and your business. As a sole proprietor, single member LLC, or even as a partner in a partnership, you’ll be required to take an owner’s draw, for which taxes are not initially withheld.
For other types of small businesses owners, such as S-corps or C-corps, the options also include taking a standard, recurring salary each pay period, for which the taxes will be withheld and sent to the IRS.
Taking the time to understand these choices and the benefits and drawbacks associated with each will save you a great deal of headache in the long run. If you still have lingering questions about how to pay yourself, talking to a tax pro is always a good next step. No two businesses are the same — nor are the needs of business owners — so someone who understands your situation better will be able to help you make the right decision between paying yourself a salary or taking an owner’s draw.
This article is for informational purposes only and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors for formal consultation.
