Paying yourself as a small business owner isn’t as simple as just withdrawing money. Get it wrong, and you could face IRS penalties, cash flow problems, or an unexpected tax bill.
Should you take a salary, an owner’s draw, or a mix of both? And how do you minimize taxes while staying compliant?
This guide breaks it down so you can confidently pay yourself the right way.
Three Paths to Payday: Salary, Draw, or Both?
Small business owners typically have three ways to take money out of their business:
- Salary – A fixed payment processed through payroll with taxes automatically withheld. This option is often required for owners of S corporations and C corporations.
- Owner’s Draw – Withdrawals from business profits, offering flexibility but requiring careful tax planning. This is common for sole proprietors, partnerships, and LLCs.
- Combination – A mix of salary and distributions, often used in S corporations, where the IRS mandates a reasonable salary while allowing additional distributions. This method can help balance stability with tax efficiency.
How Business Structure Determines Your Pay
The right approach to paying yourself depends on your business structure, tax obligations, and financial priorities.
A salary offers consistency, making it easier to budget and manage taxes, while a draw gives you more flexibility, especially if your income fluctuates. A combination of both can strike a balance, helping you manage cash flow while optimizing your tax position.
Since every business is different, it’s important to assess your long-term goals and work with a tax professional to determine the best strategy.
Your business entity type dictates how you can compensate yourself:
- Sole Proprietorship – You can take an owner’s draw, but there’s no official salary.
- Partnership – Profits are distributed among partners via draws, not salaries.
- Limited Liability Company (LLC) – Owners can take draws, or if taxed as an S corp, they must take a salary.
- S Corporation – The IRS requires owners who actively work in the business to take a reasonable salary before taking additional distributions.
- C Corporation – Owners must take a salary, but dividends may also be distributed, though they’re not tax-deductible.
Choosing the right compensation method for your business structure helps you stay compliant and manage taxes efficiently. Working with an advisor who understands the nuances of business structures (like our team at Notion CFO & Advisors) ensures you make the right decisions and avoid unexpected tax issues down the line.
Tax Implications and IRS Requirements
One of the biggest mistakes business owners make is overlooking taxes when paying themselves.
If you take a salary, payroll taxes like Social Security, Medicare, and federal and state income taxes are withheld automatically and reported on a W-2. This makes tax reporting easier but adds payroll costs for the business.
With an owner’s draw, taxes aren’t withheld upfront, so you’ll need to set aside funds for self-employment taxes and make estimated quarterly payments to avoid a hefty tax bill.
For S corp and C corp owners, the IRS requires a reasonable salary based on industry standards. Underpaying yourself to reduce payroll taxes can trigger audits and penalties.
A proactive tax strategy ensures compliance, avoids surprises, and keeps your business financially stable.
What Counts as a Reasonable Salary?
If your business structure requires a salary, the IRS expects it to be reasonable based on:
- Industry benchmarks – What others in similar roles earn.
- Your business’s revenue and profitability – A struggling business won’t justify a high salary.
- Your responsibilities – Owners heavily involved in operations should be paid accordingly.
Underpaying yourself to minimize taxes can lead to IRS audits.
Overpaying can drain your business’s cash flow.
The best approach is to use public salary data or consult a tax professional to strike the right balance.
Real-World Scenario: Salary vs. Draw
To clearly illustrate the differences between business owners taking a Salary Vs. the Draw option, let’s say you’re a small recruitment agency structured as an S corp. You work full-time in the business and take home $120,000 per year.
- If you take only an owner’s draw, the IRS may flag it because S corp owners must take a reasonable salary.
- If you take a salary of $80,000 and distribute $40,000 as a draw, you balance compliance with tax efficiency.
Simple adjustments like this can help you avoid IRS scrutiny while optimizing your tax situation.
Best Practices for Paying Yourself
Paying yourself the right way is about more than just compliance.
Here’s how to do it right:
- Keep personal and business finances separate. Use dedicated business and personal accounts to avoid IRS scrutiny and simplify bookkeeping.
- Use a payroll system. Automating salary payments helps ensure accuracy and tax compliance.
- Set aside taxes for draws. If you’re taking an owner’s draw, plan for self-employment taxes and make estimated payments to avoid surprises.
- Review cash flow regularly. Make sure your business can sustain your compensation without financial strain.
- Consult a tax professional. Get expert guidance to structure your pay in the most tax-efficient way possible.
Common Mistakes to Avoid
Many business owners make costly errors when paying themselves. Avoid these pitfalls:
- Not withholding taxes on salary payments – Leads to IRS penalties.
- Taking excessive draws without tax planning – Can result in large unexpected tax bills.
- Failing to take a reasonable salary – Increases audit risk for S corp and C corp owners.
- Ignoring cash flow limitations – Paying yourself too much can leave your business short on funds.
A well-planned compensation strategy prevents financial stress and compliance issues.
FAQ: Paying Yourself as a Small Business Owner
Do I have to pay myself every month?
Not necessarily. Sole proprietors can take draws as needed, but S corp and C corp owners must follow payroll requirements.
What happens if I don’t pay myself?
In business structures that require a salary, such as S and C corporations, failing to compensate yourself can raise red flags with the IRS.
Smart Compensation Strategies for a Stronger Business
How you pay yourself impacts your tax liability, cash flow, and long-term business success.
Understanding your options and staying compliant with IRS regulations ensures you’re making smart financial decisions.
At Notion CFO & Advisors, we help small business owners create tax-efficient pay structures that support business growth. Schedule a consultation today and let’s build a compensation strategy that works for you.