Salary or Draws? How to Pay Yourself

"How should I pay myself?" is one of the most common questions we hear from business owners. The honest answer is: it depends on how your business is set up.

Get it right and you can save real money on taxes. Get it wrong and you could be overpaying, or worse, setting yourself up for problems with the IRS. Here's a plain-English guide.

First, know your structure

How you pay yourself isn't really a choice you make on its own. It follows from your business entity type.

Business type	How owners get paid
Sole proprietor or single-member LLC	Owner's draws
Multi-member LLC (partnership)	Draws, and sometimes guaranteed payments
S corporation	W-2 salary plus distributions
C corporation	W-2 salary and/or dividends

Sole props and LLCs: owner's draws

If you're a sole proprietor or an LLC taxed as a sole proprietorship or partnership, you generally can't put yourself on payroll. Instead, you take money out of the business as a draw.

Here's the part that confuses people: draws aren't what you're taxed on. You pay tax on the business's profit, whether you take that money out or leave it in the bank. Take $50,000 out of a business that made $120,000, and you're still taxed on $120,000.

That profit is also subject to self-employment tax (Social Security and Medicare), which runs about 15.3% on most of it. That's on top of income tax, and it's often the number that makes owners start asking about S corporations.

S corporations: salary plus distributions

An S corporation works differently. If you work in the business, the IRS expects you to pay yourself a reasonable W-2 salary through payroll, with taxes withheld like any other employee.

After that, you can take additional profit out as distributions. Distributions aren't subject to Social Security and Medicare taxes. That's where the savings come from.

Say your S corp earns $150,000 in profit. If $80,000 is a reasonable salary for your role, payroll taxes apply to the $80,000, while the remaining $70,000 can come out as distributions without them. You still pay income tax on the full amount.

Why you can't just skip the salary

It's tempting to pay yourself $0 in salary and take everything as distributions. The IRS knows this, and it's a well-known audit flag. If they decide your salary was too low, they can reclassify distributions as wages and assess back payroll taxes, penalties and interest.

What counts as "reasonable compensation"?

There's no magic percentage. The basic question is: what would you have to pay someone else to do your job? The IRS looks at factors like:

• Your training, experience and duties
• How much time you put into the business
• What comparable businesses pay for similar work
• What you pay non-owner employees
• The size and profitability of the company

Write down how you arrived at your number. Good documentation is your best defense if anyone ever asks.

Common owner-pay mistakes

• Paying personal bills from the business account. It muddies your books and can weaken the liability protection your entity gives you.
• Booking draws as an expense. Draws and distributions aren't deductible. Recording them as expenses understates your profit.
• S corp distributions that don't match ownership. If there are multiple owners, distributions generally need to be in proportion to ownership.
• Forgetting your health insurance. For S corp owners with more than 2% ownership, health insurance premiums paid by the business need to be reported on your W-2.
• Electing S corp status too early. The extra payroll and tax return costs can wipe out the savings if profits aren't high enough yet.

Is an S corp right for you?

It can be, once your business is consistently profitable enough that the payroll tax savings outweigh the extra costs. In California, also factor in the 1.5% franchise tax on S corporation net income (with an $800 minimum).

If you want S corp status starting January 1, 2027, the election (Form 2553) is generally due by March 15, 2027. Now is a good time to run the numbers.

Do this before year-end

1. S corp owners: compare your 2026 salary to your distributions before the final December payroll. If salary is too low, a catch-up payroll run may make sense.
2. Sole props and LLC owners: check your profit to date and make sure your estimated payments are on track.
3. Everyone: review whether your entity structure still fits your business for 2027.

This article is for general information only and is not tax or legal advice for your specific situation. Tax rules change and individual circumstances vary, so please consult a qualified professional before acting.