How to pay yourself as a business owner depends on your business structure and how it is taxed. Transferring money from your business account to your personal account does not automatically make that payment an owner draw. It could be a member distribution, shareholder distribution, wage, dividend, or another type of transaction.
Understanding the difference can help you maintain accurate books and avoid potential tax problems.
Owner draws for sole proprietors
Sole proprietors generally do not pay themselves through payroll. Instead, they take owner draws.
An owner draw is not recorded as a business expense. It reduces the owner’s equity in the business. Sole proprietors are also generally taxed on the business’s net profit, not on the amount they withdraw.
For example, if your business earns $50,000 in profit but you only withdraw $20,000, your taxable business income is not limited to that $20,000.
How LLC owners pay themselves
An LLC is a legal structure, but it can be taxed in different ways. That tax classification affects how to pay yourself as a business owner.
A single-member LLC taxed as a sole proprietorship will generally use owner draws. A multi-member LLC taxed as a partnership may make member distributions.
Partners are generally not employees of the partnership. They should not receive a W-2 in place of the Schedule K-1 used to report their share of partnership income. A partner may also receive guaranteed payments for services or the use of capital.
Partners generally report their share of the partnership’s income even if the business does not distribute all of that income to them.
Paying yourself through an S corporation
If you own an S corporation and actively work in the business, you generally cannot classify every payment as a shareholder distribution.
Shareholder-employees generally must receive reasonable compensation through payroll for the services they provide. After considering reasonable compensation and the company’s circumstances, they may also receive shareholder distributions.
Wages compensate you for your work. Distributions reflect your ownership interest. Because these payments receive different tax treatment, the IRS may examine cases in which an owner takes distributions while receiving little or no salary.
Wages and dividends from a C corporation
A C corporation is a separate tax entity from its shareholders. If you work for the corporation, you may receive wages through payroll. If the corporation distributes profits to you as a shareholder, the payment may be treated as a dividend.
The corporation generally pays tax on its profits, and shareholders may also owe tax on dividends. This is often called double taxation.
Record every transaction correctly
Learning how to pay yourself as a business owner also means understanding the direction and purpose of each transaction.
Money you contribute to the business is not the same as money you withdraw. Depending on the circumstances, money going into the business could be recorded as an owner contribution, member contribution, shareholder contribution, or loan.
Do not rely on the memo line of a transfer to classify the transaction. Your entity type, tax classification, ownership, and the reason for the payment all matter.
Before moving money between your business and personal accounts, speak with your bookkeeper or tax professional about the correct method. Getting it right from the beginning can prevent bookkeeping cleanup and potentially expensive tax issues later.
Key Notes
- Sole proprietors and single-member LLCs taxed as sole proprietorships generally use owner draws.
- Multi-member LLCs taxed as partnerships may make member distributions or guaranteed payments.
- Partners generally report their share of partnership income even when that income is not distributed.
- S corporation shareholder-employees generally need reasonable compensation through payroll before taking non-wage distributions.
- C corporation owners may receive wages and taxable dividends.
- Every payment should be classified according to the business structure, tax treatment, and purpose of the transaction.
