When you own a business, getting paid isn’t always as simple as writing yourself a check. Should you take an owner’s draw? Should you put yourself on payroll and receive a salary? Or should you use another method entirely?

The answer depends largely on how your business is structured and taxed. Choosing the wrong method can create bookkeeping problems, payroll tax issues, and potentially expensive tax consequences.

Here’s what business owners should know about an owner’s draw versus a salary.

What Is an Owner’s Draw?

An owner’s draw is money an owner takes out of the business for personal use.

For example, imagine your business has $30,000 available in its bank account. You transfer $3,000 from the business account to your personal account.

Depending on your business structure and circumstances, that transfer may be recorded as an owner’s draw rather than payroll.

An owner’s draw is generally not recorded as a business wage expense. Instead, it typically reduces the owner’s equity in the business.

What Is a Salary?

A salary is compensation paid to an employee for work performed for the business.

When a business owner is properly treated as an employee, salary generally runs through payroll just like compensation paid to other employees.

That means the business may need to:

• Calculate payroll taxes
• Withhold applicable federal income tax
• Withhold Social Security and Medicare taxes
• Pay applicable employer payroll taxes
• Make payroll tax deposits
• File required payroll tax returns
• Issue a Form W-2

Salary and owner’s draws are therefore treated very differently for accounting and tax purposes.

Owner’s Draw vs. Salary: The Basic Difference

Owner’s Draw	Salary
Generally a withdrawal of owner equity	Compensation for services performed
Generally not processed through payroll	Processed through payroll
Generally not a wage expense	Generally recorded as compensation expense when deductible
No payroll withholding directly from the draw itself	Applicable payroll taxes and withholding apply
Common with certain noncorporate business structures	Generally required for shareholder-employees of corporations when applicable

However, you generally can’t simply choose whichever method results in the lowest tax bill. Your business’s tax classification matters.

Sole Proprietorship: How Do You Pay Yourself?

If you’re a sole proprietor, you generally don’t put yourself on payroll as an employee of your own sole proprietorship.

Instead, you can typically take money from the business as an owner’s draw.

Here’s an important point:

Your taxes generally aren’t based on how much money you draw from the business.

They’re generally based on the business’s taxable net profit.

For example, suppose your sole proprietorship has:

• $100,000 in business revenue
• $60,000 in deductible business expenses
• $40,000 in net business profit

If you only transfer $20,000 to your personal bank account during the year, that doesn’t necessarily mean you’re taxed on only $20,000.

Your federal tax calculation generally begins with the business’s $40,000 net profit, subject to the tax rules that apply to your situation.

This distinction surprises many new business owners.

Single-Member LLC: Draw or Salary?

An LLC is a legal business structure, but the letters “LLC” alone don’t tell you how the business is taxed.

For federal income tax purposes, a single-member LLC is generally treated as a disregarded entity unless it elects another tax classification.

If your single-member LLC is taxed like a sole proprietorship, you would generally pay yourself through owner withdrawals rather than putting yourself on payroll as an employee of the disregarded entity.

However, if the LLC elects to be taxed as an S corporation or C corporation, the rules can be very different.

This is why knowing your LLC’s tax classification is so important.

What About Partnerships?

Partners generally aren’t employees of the partnership for federal tax purposes and shouldn’t receive a Form W-2 simply for performing services as partners.

Partners may receive distributions from the partnership.

They may also receive guaranteed payments for services or the use of capital. Guaranteed payments are generally payments determined without regard to the partnership’s income.

Partnership taxation can become complicated quickly, particularly when multiple owners, guaranteed payments, distributions, capital accounts, and self-employment tax are involved.

S Corporation Owners: Salary Becomes Very Important

This is where the owner’s draw versus salary conversation becomes particularly important.

If you’re a shareholder who performs more than minor services for an S corporation and receives or is entitled to compensation, you may be considered a shareholder-employee.

The IRS requires S corporations to pay shareholder-employees reasonable compensation for services performed before making non-wage distributions to that shareholder-employee.

In other words, an S corporation owner generally can’t simply take all of the company’s money as distributions while paying themselves little or no salary when they are actively performing substantial services for the business.

What Is Reasonable Compensation?

There isn’t one salary amount that automatically qualifies as reasonable for every S corporation owner.

The appropriate amount depends on the facts and circumstances.

Factors that can be considered include:

• Your training and experience
• Your duties and responsibilities
• How much time you devote to the business
• What similar businesses pay for similar work
• Payments made to non-shareholder employees
• Your compensation agreement
• The nature of the business
• How the business generates its revenue

For example, the reasonable compensation for a business owner working five hours per week handling administrative tasks may look very different from the compensation for an owner working 50 hours per week personally generating most of the company’s revenue.

Why Can’t an S Corporation Owner Just Take Distributions?

One reason this area receives IRS attention is that wages are generally subject to employment taxes, while qualifying S corporation distributions generally aren’t subject to employment taxes in the same manner.

That can create an incentive for some owners to artificially reduce their salary and increase distributions.

The IRS can examine the facts and potentially reclassify distributions or other payments as wages when they actually represent compensation for services.

If that happens, the business could potentially face additional employment taxes, penalties, and interest.

Does an Owner’s Draw Reduce Your Business’s Profit?

Generally, no.

This is another common misunderstanding.

An owner’s draw is generally an equity transaction rather than a deductible business expense.

For example:

Your business earns $80,000 in revenue and has $50,000 in deductible expenses.

Your net business profit is:

$80,000 – $50,000 = $30,000

Now suppose you take a $10,000 owner’s draw.

That withdrawal generally doesn’t turn your $30,000 business profit into $20,000 of profit.

The draw is generally recorded separately in your bookkeeping records.

Don’t Confuse a Draw With a Business Expense

When you transfer money from your business to yourself, it needs to be categorized correctly.

Owner withdrawals shouldn’t simply be placed into a random business expense category to reduce profit.

Doing so can distort your Profit & Loss Statement and potentially cause incorrect deductions to appear on your tax return.

Your bookkeeping should clearly distinguish among:

• Business expenses
• Owner draws or distributions
• Payroll
• Owner contributions
• Loans
• Other equity transactions

How Much Should You Pay Yourself?

There’s no universal percentage of revenue or profit that every business owner should pay themselves.

The appropriate amount can depend on:

• Your business structure
• Your tax classification
• Business profitability
• Cash flow
• Upcoming expenses
• Tax obligations
• Debt payments
• Growth plans
• Payroll requirements
• Your personal financial needs

Taking too much money out of a business can create cash flow problems, even when the company appears profitable on paper.

A $10,000 Bank Balance Doesn’t Mean You Can Take $10,000

Before transferring money to yourself, remember that some of the cash sitting in your business account may already be needed for:

• Payroll
• Payroll taxes
• Estimated taxes
• Sales taxes
• Rent
• Insurance
• Vendor bills
• Inventory
• Loan payments
• Upcoming operating expenses

That’s why paying yourself should be part of a broader cash flow plan rather than simply transferring whatever happens to be available in the bank.

Common Mistakes Business Owners Make

Some common problems include:

• Putting themselves on payroll when their tax structure doesn’t support that treatment
• Taking only distributions from an S corporation despite performing substantial services
• Paying an unreasonably low S corporation salary
• Recording owner draws as deductible business expenses
• Paying personal bills directly from the business account without proper bookkeeping
• Taking too much cash out of the company
• Failing to make estimated tax payments when required
• Not documenting distributions and owner transactions
• Assuming every LLC owner follows the same tax rules

Should You Take an Owner’s Draw or Salary?

The answer depends primarily on your business’s legal structure and federal tax classification.

A sole proprietor may generally take owner’s draws.

A partner generally receives distributions and may receive guaranteed payments rather than employee wages for services performed as a partner.

A shareholder-employee of an S corporation who performs services generally needs to consider reasonable compensation and payroll requirements before taking non-wage distributions.

A corporate owner who is also an employee may receive wages through payroll.

Because the rules vary considerably, don’t choose how to pay yourself based solely on what another business owner does.

Pay Yourself the Right Way With PFGTAX

How you pay yourself can affect your bookkeeping, payroll, cash flow, and taxes.

PFGTAX can help business owners understand how their business is taxed, maintain accurate bookkeeping records, manage payroll, plan for taxes, and evaluate the proper way to take money from the business.

Whether you’re operating as a sole proprietor, LLC, partnership, S corporation, or corporation, having the right system in place can help prevent costly mistakes.

Not sure whether you should take an owner’s draw, distribution, guaranteed payment, or salary? Contact PFGTAX to review your business structure and determine the appropriate approach for your situation.

This article is for general educational purposes and isn’t individualized tax, accounting, financial, payroll, or legal advice. The appropriate method of paying a business owner depends on the entity’s legal structure, tax classification, ownership arrangement, services performed, and other circumstances.