How to Pay Yourself as a Small Business Owner

By Jason Koscinski

One of the most common questions I hear from small business owners is also one of the simplest: "How am I supposed to pay myself?" You started the business to earn a living, but the right way to move money from the business to you depends on how the business is set up for tax purposes. Get it wrong and you can end up with messy books, a surprise tax bill, or payroll problems that are a pain to unwind.

Here's a plain-English walk-through of the main options, what the IRS expects for each, and how to keep it clean in your books. It's written for owners in Kalamazoo and across West Michigan, but the federal rules are the same everywhere.

Start with your tax structure, not your bank balance

The IRS puts it simply: how you pay yourself depends on the type of business structure you've chosen. Its Paying yourself page walks through the common situations. The big buckets are:

• Sole proprietors and single-member LLCs (taxed the default way)
• Partnerships and multi-member LLCs
• S corporations (including LLCs that elected S corp status)
• C corporations

If you're not sure which one you are, check your most recent business tax return or ask your tax preparer before you change anything. The answer drives everything below.

Sole proprietors and single-member LLCs: the owner's draw

If you're a sole proprietor or a single-member LLC taxed the default way, you generally don't put yourself on payroll. You take an owner's draw: you transfer money from the business account to your personal account when you need it.

A draw isn't a business expense. It doesn't lower your taxable profit. You're taxed on the business's net profit whether you take the money out or leave it in the account. As the U.S. Small Business Administration notes, LLC members are considered self-employed and pay self-employment tax toward Social Security and Medicare.

That's why the most important habit here isn't the draw itself. It's setting money aside for estimated taxes, because no one is withholding for you.

In your books, draws should go to an owner's draw (equity) account, not to an expense account like "wages" or "miscellaneous." I see this mistake constantly, and it makes the profit and loss statement look worse than it really is.

Partnerships and multi-member LLCs: draws and guaranteed payments

Partners aren't employees. The IRS says partners should not be issued a Form W-2 for distributions or guaranteed payments from the partnership. Those amounts are reported to each partner on Schedule K-1 instead.

In practice, partners usually take distributions, and some partnerships also set up guaranteed payments for partners who do the day-to-day work. Your partnership or operating agreement should spell out who gets paid what and when. If it doesn't, that's worth fixing before money starts moving unevenly between partners.

For bookkeeping, give each partner their own draw (equity) account so you can see at a glance who has taken what during the year.

S corporations: reasonable salary first, then distributions

This is where most of the confusion lives. If your business is an S corporation, and you work in it, you're generally an employee of your own company. The IRS is direct about it on its S corporation compensation page: an S corporation must pay reasonable compensation to a shareholder-employee for the services they provide before taking non-wage distributions.

That means two kinds of payments:

• Salary through payroll, with income tax withheld and payroll taxes paid, reported on a W-2.
• Distributions of profit, which are not wages.

The IRS also has the authority to reclassify distributions as wages if the salary is too low. So "pay myself $0 in wages and take everything as distributions" is not a plan. And you can't sidestep it by issuing yourself a 1099. The IRS says you can't make yourself (or anyone else) an independent contractor just by issuing a 1099-NEC instead of a W-2. If a corporate officer is treated as a nonemployee, the company can be liable for the Social Security, Medicare, and income tax that should have been withheld, and possibly the trust fund recovery penalty.

We cover the bigger-picture trade-offs in our S-Corp vs LLC guide.

What counts as "reasonable" compensation?

There's no single number. The IRS says the key is looking at what you actually do for the business and where the company's gross receipts come from: your own services, the work of non-owner employees, or capital and equipment. Factors the IRS lists include:

• Your training and experience
• Your duties and responsibilities
• The time and effort you put into the business
• What the business pays non-owner employees
• What comparable businesses pay for similar services
• The company's history of dividends and how bonuses are paid

A good practical step is to write down how you arrived at your salary and keep that note with your records. If you're the owner and the main person doing the work that brings in revenue, expect a larger share of what you take to be salary. Your tax preparer should weigh in on the number.

A year-end item S corp owners often miss: health insurance

Since it's November, here's one to check now. If your S corporation pays health insurance premiums for an owner who holds more than 2 percent of the company, the IRS says those premiums are reported as wages in Box 1 of the owner's W-2. They generally aren't included in the Social Security and Medicare wage boxes (Boxes 3 and 5) when the plan meets the IRS conditions.

This has to be handled through payroll before the year's final W-2s are prepared, so tell whoever runs your payroll about those premiums well before December's last payroll. For more on the January filings, see our year-end W-2 and 1099 checklist.

C corporations: salary and dividends

If you own a C corporation and work in it, you're generally an employee paid through payroll, like an S corp owner. Profits paid out to shareholders are generally dividends, which the IRS treats differently from wages. If you borrow from your own corporation, the IRS expects it to look like a real arm's-length loan, with a written agreement, an interest rate, and a repayment schedule.

Keep owner pay clean in your books

Whatever your structure, a few habits save headaches at tax time:

• Pay yourself from the business account. Keep business and personal money separate, and move money with a transfer you can trace.
• Pick a rhythm. Monthly or twice-monthly draws or distributions are easier to track and plan around than random transfers. A 13-week cash forecast helps you see what you can safely take.
• Use the right accounts. Draws and distributions go to equity. Salary goes through payroll. Personal expenses paid with the business card get recorded as draws or distributions, not business expenses.
• Plan for taxes. If no one is withholding for you, set aside money for estimated payments.
• Review the totals before year-end. Compare what you took to what the business earned, so there are no surprises.

How JRK Financial helps

JRK Financial keeps the books for small businesses in Kalamazoo, Michigan, and across West Michigan. We record owner draws and distributions in the right accounts, and for payroll clients we run payroll through Gusto, so an S corp owner's salary is processed like any other employee's and ties to your books. You can read more in our post on payroll for Kalamazoo small businesses. If you want a regular sounding board on cash and owner pay, our Small Business Financial Advisor service is built for that.

We don't set your salary for you or give tax advice on your return. We'll give you clean numbers so you and your tax preparer can make that call with confidence.

FAQ

Is an owner's draw taxable?

For a sole proprietor or single-member LLC, the draw itself isn't what's taxed. You're taxed on the business's net profit, whether or not you take it out.

Can I pay myself through payroll if I'm a sole proprietor?

Generally, no. Sole proprietors take draws. Payroll for the owner usually comes into play when the business is taxed as a corporation, such as an S corp.

Can an S corp owner skip salary and take only distributions?

Not if you work in the business. The IRS requires reasonable compensation before non-wage distributions and can reclassify distributions as wages.

Should I issue myself a 1099?

No. The IRS says a 1099-NEC doesn't make someone an independent contractor, and that includes you as a corporate officer.

Let's get your owner pay set up right

If you're not sure your owner pay is set up the right way, or your draws and distributions are scattered across the wrong accounts, I'm happy to take a look. Send me a message or call 269-200-2910. JRK Financial is based in Kalamazoo, Michigan, and works with small businesses across West Michigan.