Key Takeaways
- How an owner can be paid depends on the entity: owner's draws in sole proprietorships and most LLCs, salary plus distributions in S corporations, and salary plus dividends in C corporations.
- Sole proprietors and default LLC owners pay 15.3% self-employment tax on net earnings regardless of how much they withdraw.
- S corporation owners who work in the business must take reasonable compensation; IRS Fact Sheet FS-2008-25 explains the requirement.
- Retirement contributions, accountable plan reimbursements, and health insurance can move more of an owner's pay into tax-advantaged forms.
- The best mix balances income tax, payroll tax, the QBI deduction, and retirement goals.
The most tax-efficient way to pay yourself depends on your entity. In an S corporation, owners typically take a reasonable salary and the rest as distributions, which are not subject to payroll tax. Sole proprietors and default LLC owners take draws but pay self-employment tax on all profit. C corporation owners combine salary and dividends.
Owner pay is one of the few tax decisions you control every month. Certified Maverick, the certification and directory network for tax strategists founded by David A. Perez, trains advisors to set and review owner compensation as part of year-round planning. This guide explains how to pay yourself as a business owner, how each method is taxed, and how to weigh owner salary vs distributions in an S corporation.
How Can Business Owners Pay Themselves?
| Entity | How the owner is paid | How it is taxed |
|---|---|---|
| Sole proprietorship or single-member LLC | Owner's draw | Not deductible; all net profit is subject to income tax and 15.3% self-employment tax |
| Multi-member LLC (partnership) | Draws and guaranteed payments | Each partner pays income tax and self-employment tax on their share of earnings |
| S corporation | Salary plus distributions | Salary is subject to payroll tax; distributions are not, but both are subject to income tax |
| C corporation | Salary plus dividends | Salary is deductible to the company; dividends are taxed at the corporate level and again to the shareholder |
Is an Owner's Draw Taxed?
An owner's draw is not taxed as a separate payment. In a sole proprietorship or default LLC, the owner pays income tax and self-employment tax on the business's entire net profit, whether the money is withdrawn or left in the account. Self-employment tax is 12.4% for Social Security up to the annual wage base, plus 2.9% for Medicare on all earnings.
How Should S Corporation Owners Split Salary and Distributions?
S corporation owners who provide services to the business must receive reasonable compensation before taking distributions. IRS Fact Sheet FS-2008-25 explains that the IRS can reclassify distributions as wages when salary is too low.
Factors the IRS and courts consider include:
- The owner's training, experience, duties, and responsibilities
- Time and effort devoted to the business
- What comparable businesses pay for similar services
- Compensation agreements and the company's dividend history
- The timing and manner of paying bonuses
In Watson v. United States (8th Circuit, 2012), a CPA who paid himself $24,000 a year had his wages reassessed at about $91,000, with back payroll taxes owed. Documenting how a salary was set, for example with salary survey data, reduces this risk.
How Do C Corporation Owners Pay Themselves?
C corporation owners usually combine a salary, which the corporation can deduct, with dividends, which it cannot. Profits are taxed at the 21% federal corporate rate, and dividends are taxed again to the shareholder at up to 20%, plus the 3.8% net investment income tax for higher earners. Owners often favor salary, bonuses, and benefits over dividends, but compensation must still be reasonable for the work performed.
What Other Tax-Efficient Ways Can Owners Take Money Out?
- Retirement plan contributions. A Solo 401(k), SEP IRA, or cash balance plan lets the business make deductible contributions on the owner's behalf. For S corporation owners, employer contributions are based on W-2 salary.
- Accountable plan reimbursements. Under an accountable plan, the business can reimburse owners for documented business expenses, such as a home office or mileage, without the payments counting as income.
- Health insurance. S corporations can pay health insurance premiums for more-than-2% shareholders; the premiums are included in W-2 wages but may be deductible by the owner.
- Hiring family members. Paying children or a spouse a reasonable wage for real work can shift income, subject to payroll rules that depend on the entity type.
- Health savings accounts. Owners with a qualifying high-deductible health plan can contribute to an HSA.
How Does Owner Pay Affect the QBI Deduction?
For S corporation owners, salary is not qualified business income, so a higher salary reduces the Section 199A deduction. Above the income threshold, though, the deduction can be limited by W-2 wages paid, and the owner's salary counts toward that limit. The right salary balances payroll tax, the QBI deduction, and retirement contribution goals.
What Are the Risks and Limitations?
- A salary that is too low invites IRS reclassification, back payroll taxes, and penalties.
- Paying owners through loans instead of salary can be recharacterized as wages or distributions.
- Distributions in excess of an S corporation shareholder's basis can be taxable.
- Accountable plans, family employment, and retirement plans all require documentation and compliance with IRS rules.
What's the Bottom Line?
How you pay yourself depends on your entity. Sole proprietors and default LLC owners pay self-employment tax on all profit, S corporation owners split pay between a reasonable salary and distributions, and C corporation owners balance salary and dividends. Retirement contributions, accountable plans, and benefits can move more pay into tax-advantaged forms. Setting and documenting a reasonable salary is the most important step for S corporation owners.
Frequently Asked Questions
Pay yourself a reasonable salary through payroll, then take remaining profit as distributions, which are not subject to payroll tax. Add deductible retirement contributions and accountable plan reimbursements where they fit. The salary must reflect your duties and market pay, as explained in IRS Fact Sheet FS-2008-25.
It depends on the entity. Sole proprietors and default LLC owners cannot pay themselves a salary for tax purposes; they take draws and pay self-employment tax on all profit. S corporation owners must take a reasonable salary if they work in the business. The choice is really about entity structure.
An amount that is reasonable for the services you provide, based on your duties, time, experience, and what similar businesses pay. Many advisors use salary survey data to support the figure. A salary that is too low can be reassessed by the IRS, as in Watson v. United States (2012).
Distributions are not subject to payroll tax, but the S corporation's profit is still subject to income tax on the owner's personal return, whether distributed or not. Distributions above the shareholder's stock basis can also be taxed as capital gain.
Yes, if they perform real work at a reasonable wage and you keep records such as timesheets. Payroll tax treatment depends on the entity: some exemptions apply to children under 18 working for a parent's sole proprietorship, but not to wages paid by an S corporation or C corporation.