The way you set up your business has a ripple effect. Impacting everything from how you manage money in the business and how much you owe in taxes to how you actually pay yourself.
Two basic methods exist for how to pay yourself as a business owner: the owner’s draw method and the salary method. They have different tax implications and are reserved for different types of businesses. Their impact on your tax bill could determine how you choose to structure your business – so get familiar with them!
In this guide, we’ll compare the owner’s draw versus salary methods to help you understand the best way to pay yourself as a business owner.
How do business owners pay themselves?
How you pay yourself when you’re self-employed depends on how you structure your business – even as a Business-of-One. How you’re set up legally determines how you’ll be taxed, and that determines your payment method and how you report it.
It all starts with the legal structure of your business. You might operate as:
There’s no legal or tax distinction between you and the business. You operate this way if you’re a freelance service provider, for example, and you haven’t taken any steps to organize your business as a legal entity.
A default partner is like a sole proprietorship split among multiple people. There’s no separate business for legal or tax purposes. You simply split profits among the partners. A general or limited partnership is distinct from the owners and limited partners don’t have liability.
A limited liability company is a separate legal entity for your business and could be a single-member (just you) or multi-member (you and other owners). For tax purposes, an LLC could be treated like a sole proprietorship or partnership. Or you could file a form to request to be treated as an S Corp, which taxes you and the business separately.
A corporation is a separate legal entity for your business with complex taxation and a separate tax rate from individuals.
As a Business-of-One, you’ll most likely operate as a sole proprietor or organize as a single-member LLC.
The IRS always taxes a sole proprietor as a sole proprietorship, very literal, we know. It also taxes a single-member LLC as a sole proprietorship by default, but you could elect to instead be taxed as an S Corp. In rare cases, an LLC could be taxed as a C Corp, but we won’t dig into that option here – consult with a tax pro if you want to explore it more.
Most states that collect income tax recognize S Corp status and tax you and your business along the same lines as the IRS – but not all. Ask a tax pro about sole proprietor and S Corp taxes in your state.
Whether you’re taxed as a sole proprietor versus an S Corp determines how you pay yourself when you’re self-employed.
How to pay yourself as a sole proprietor
As a sole proprietor, for tax purposes, business revenue and assets aren’t distinguished from your personal income and assets (even if they’re legally separate because you’re an LLC). All the money that comes into the business is your income, and anything owned by the business is your property.
Because of this setup, when you take money for yourself, it’s called an owner’s draw (or just “draw”).
What is an owner’s draw?
An owner’s draw is what happens anytime you take money out of the business for personal use. It’s an accounting term and doesn’t have implications for your income taxes.
The definition of an owner’s draw could be a little fuzzy, depending on how you manage money in your business.
Here are a few examples of what you’d call an owner’s draw:
- You’re a sole proprietor, and you keep two personal bank accounts: one for personal expenses and one for business income and expenses. Anytime you move money from the “business” account to the “personal” account is an owner’s draw.
- You’re an LLC, and the LLC owns a business bank account where you deposit payments from clients. You schedule twice-monthly deposits from the LLC account into your personal bank account – that deposit is an owner’s draw.
- You’re a sole proprietor, and you manage all of your money in one bank account. Clients pay you into that account, and you use that account to pay your household bills. Technically, all that money is an owner’s draw (though an accountant would have a tough time properly tracking it).
The amount and timing of an owner’s draw doesn’t have to be consistent. You can simply take out money when you need it for personal expenses or when you know the business has enough to spare.
Keeping track of an owner’s draw is important for your internal bookkeeping. It helps you track how money in the business is used, so you can see what you’re keeping for personal use versus what you have available in the business to pay bills and pursue projects or growth.
But you don’t have to report an owner’s draw on your income tax return. That’s because, when you’re taxed as a sole proprietor, you report all income into the business as your income on your tax return.
Basically, an owner’s draw is just a way of moving money around, not a different form of income.
How to pay yourself as an S Corp
If you set up your business as an LLC, so there’s a separate legal entity, you can elect with the IRS to be taxed differently, too. That option is called an S Corp.
With an S Corp election, it is a tax election which allows any profit and loss to flow through to itd owner or owners (i.e. the business’s profits and losses are passed through to the owner).
Unlike a sole proprietorship, though, an S Corp owner can receive two types of income that are taxed differently — W2 salary and distributions.
What is a salary?
The W2 salary you pay yourself as an S Corp is just like one you’d receive as an employee of someone else’s company. It’s a defined amount of money you receive regularly– like monthly, weekly, bi-weekly or twice a month.
You might pay yourself this way as a sole proprietor: scheduling regular transfers from your business bank account to your personal. But that doesn’t count as a “salary” for tax purposes.
The salary your received as the owner comes to you as a paycheck by direct deposit or other payment method. You can set it up to automatically deduct payroll taxes (just like any other employer) through a payroll tool, like Collective Payroll. It gets reported as income on your annual tax return.
You can adjust your salary – and, therefore, your next paycheck – anytime. But that could be pretty inconvenient if your business has irregular cash flow and you can’t predict when or how much you can afford to pay yourself.
However, to take advantage of the self-employment tax that an S Corp provide, the owner must run payroll.
What is a distribution?
A profit distribution is any money you take out of your S Corp company outside of your salary. Only owners (also called shareholders) can receive a distribution.
Typically, owners receive profit distributions on a set schedule, like monthly or quarterly, based on their share of the company’s profits for the period. Those details should be included in your operating agreement if you have business partners.
As a Business-of-One, you can basically take a distribution whenever you want or need it, as long as it’s proportionally reasonable to the salary paid. But doing it without a schedule could make accounting a challenge.
Because it’s money you take from your business for personal use, a profit distribution sounds like an owner’s draw. It’s similar. You take cash from your business. For tax purposes, though, they’re not the same.
Draws and distributions both have tax implications. The distribution or draw itself is not a taxable event. The owner pays income tax on the profit reported at the end of the year which would cover all distributions or draws. Draws are also subject to self employment tax.
Owner’s draw vs. salary method: How are they taxed?
The biggest difference between paying yourself via a draw method versus a salary method is in how they’re taxed.
Owner’s draw and sole proprietor taxes
When you’re taxed as a sole proprietorship, the IRS makes no distinction between you and your business. Any money you earn from your business activities counts as your personal income.
You won’t report any draws on your income tax return, so paying yourself through the owner’s draw method doesn’t impact your taxes.
If you’re a service provider, you’ll work with clients as a 1099 employee, also known as an independent contractor. Clients pay you for services, and they don’t pay any taxes on your behalf (the way an employer would).
You’re responsible for two types of taxes: income tax and what’s commonly referred to as self-employment tax.
- Self-employment tax is a catchall term for two tax charges: a 12.4% tax for Medicare and a 2.9% tax for Social Security. If you were an employee, your employer would pay half of that, and the other half would automatically come out of your paychecks. When you’re self-employed, you owe the full amount, and you have to handle the payments.
- Income tax is the amount you owe on your annual earnings, minus tax deductions and credits. An estimated amount would also come out of your paycheck automatically if you were employed, but you have to pay it manually when you’re self-employed.
When you’re self-employed, you have to deal with taxes year-round, not just in the spring. That’s because you don’t have an employer handling those payments for you.
You’re required to make estimated tax payments each “quarter” – which, usually, the IRS divides unevenly throughout the year. Estimated payments are based on your expected income for the year ahead. You can figure out how much to pay using the IRS Form 1040-ES. Payments are due each year on:
- April 15th
- June 15
- September 15th
- January 15th of the next year
As a sole proprietor, you have to claim all the money you make through your business as personal income, even if only a portion of it goes to personal use. You still get to claim business-related expenses as tax deductions, but you can’t designate any amount of earnings as non-earnings just because you don’t put them in your personal bank account, for example.
You pay self-employment tax and income tax on all the money you make as a sole proprietor. Just like any other worker, your income tax rate is based on your tax bracket, which is determined by the amount of taxable income your report.
Taxes on S Corp distributions vs. salary
An S Corp owner would use the salary method. Through this method, you can be paid through both salary and distributions, which are taxed differently:
- Salary: Your salary is taxed like the sole proprietor income described above. You owe full self-employment tax and income tax on the taxable amount.
- Distributions: You don’t owe self-employment tax on profit distributions as an S Corp owner – exciting news! But you do pay income tax on all your S Corp profits, including profits that you distribute to yourself. Your S Corp’s pass through profit is added to your taxable income, so they could affect your tax bracket and rate.
The gist: You only pay 15.3% on your salary, and not your S Corp profits.
So… why would you pay yourself a salary at all? The IRS requires it. Because, taxes!
An S Corp owner who works in the business has to receive what the IRS deems a reasonable salary. Basically, “reasonable” means an amount similar to what you’d earn working for someone else’s company doing the same job you do inside your own company.
You also can’t avoid extra income tax by not taking profit distributions for the year. You have to claim profits not paid in salary as income on your tax return, even if you leave it sitting in your LLC’s bank account. (Remember: Profits are passed onto you. The IRS doesn’t see the company as a separate entity.)
To pay S Corp taxes, you could pay estimated quarterly taxes to cover your payroll tax and estimated income tax. Or you can set up payroll through a tool like Gusto, which automatically deducts and pays taxes for salary payments, then sends you your take-home pay.
Owner’s draw vs. salary method: Pros and cons of each
The choice between payment methods as a business owner is actually a choice between the ways you can be taxed.
Remember: If you operate as a sole proprietor (no separate legal entity), you can only be taxed as a sole proprietorship. If you operate as an LLC (by registering a separate legal entity), you can elect to be taxed as a sole proprietorship or an S Corp.
Sole proprietors are paid through the owner’s draw method, and S Corp owners are paid through a combination of salary and distributions.
How each method impacts your tax bill will probably determine how you structure your business. Being taxed as an S Corp could mean serious tax savings if your income is well above a “reasonable salary” for your work, so the minor expense and hassle of organizing an LLC could be worth it to get access to this tax treatment.
Owner’s draw method
- No need to create a separate business entity
- Simpler accounting
- Simpler tax reporting
- Flexibility in when and how much you pay yourself
- Pay self-employment taxes on full income
- Less structure in your take-home pay
- Difficult to automate tax payments
- No self-employment taxes on profits.
- Stability in your take-home pay schedule and amount.
- Easy to automate payroll and tax payments.
- More organized business accounting.
- Need to organize an LLC and file for S Corp election.
- Not all states recognize S Corp status.
- Inconvenient if you have to change your pay amount.
- More tax forms to file.
How to pay yourself as a business owner by business type
Wondering the best way to pay yourself as a business owner? The answer is in your business structure. Here’s a quick look at how you handle paying yourself as an owner in each type of business entity.
FAQs about paying yourself as a business owner
Is an owner’s draw considered income?
Yes… and no. You don’t report an owner’s draw on your tax return, but you do report all of your business income from which you make the draw. So, the money you take as an owner’s draw will be taxed. You just don’t have to report it twice.
Can you deduct an owner’s draw?
No. You don’t report an owner’s draw on your tax return, and it doesn’t count as a business expense for tax purposes. You only track it for internal accounting purposes.
How much should a sole proprietor set aside for taxes?
As a sole proprietor, you’ll pay a 15.3% self-employment tax for Medicare and Social Security, plus income tax based on your tax bracket. The latter is determined by your total taxable income for the year, which you can estimate using IRS Form 1040-ES.
What is the owner’s draw tax rate?
You don’t report an owner’s draw on your tax return, so the money doesn’t come with a unique tax rate. Instead, you report all the money your sole proprietorship earns as personal income, and you pay an income tax rate based on your tax bracket. Tax rates for sole proprietors are the same as the individual income tax rate, between 10% and 37% as of 2024.
How are S Corp distributions taxed?
S Corp distributions are taxed as part of your income for the year. You report any profits you receive from your business as income on your tax return. The amount is added to your taxable income, which could affect your tax bracket and increase your tax rate. You don’t pay self-employment tax on distributions.
Do sole proprietors pay more taxes than S Corps?
Electing S Corp instead of sole proprietorship treatment could mean tax savings for some businesses. Generally, you could save taxes as an S Corp if you’re earning more from your business than a typical salary for someone in your field. A tax professional can help you determine the tax implications of each structure and choose the right one for your business.
Which is better for taxes LLC or sole proprietorship?
An LLC, which is a legal structure for your business, could be taxed as either a sole proprietorship or an S Corp (or, rarely, a C Corp). Either tax treatment is fine for an LLC, but an S Corp election could save you money if your business earns significant revenue. Work with your accountant to determine the best way to organize and tax your business if you want to reduce your tax liability.
TL;DR: What is the best way to pay yourself as a business owner?
How you pay yourself as a business owner is determined by how your business is structured. Or, if you’re planning ahead, you might structure your business based on how you want to structure payment and taxes.
If you sell goods or offer your services without registering a separate business entity, you’re considered a sole proprietor. Your take-home pay is considered an owner’s draw, an action you don’t have to report for taxes. You pay taxes as an individual on all the money your business earns.
If you register an LLC, you could ask the IRS to consider you an S Corp instead. In that case, you pay yourself a salary and take distributions from the business’s profit, and you could pay less in self-employment taxes.
An S Corp, the salary payment method is attractive for a lot of business owners because of potential tax savings. But it requires you to organize an LLC, which comes with a small expense and some additional legal requirements. Work with your accountant to determine the best business structure, tax treatment and payment method for your business.