Understanding Owner's Draw vs Salary: How to Pay Yourself the Right Way

When you started your business, you probably didn't think much about how you'd pay yourself. Maybe you just transferred money when you needed it, or set up a regular payment without considering the tax implications. But how you compensate yourself isn't just a bookkeeping detail—it directly affects your tax bill, cash flow, and even how lenders view your business.

The question of owner's draw vs salary comes down to one critical factor: your business entity type. Let's break down what works for LLCs, S-Corps, partnerships, and sole proprietorships.

What's the Difference Between Owner's Draw vs Salary?

Owner's Draw: Money you take out of your business equity. Think of it as withdrawing from your ownership stake. You're not an employee—you're taking a distribution of profits or equity.

Salary: Regular compensation you pay yourself as an employee of your business, with payroll taxes withheld and W-2 reporting at year-end.

The method you use depends entirely on your business structure.

Sole Proprietorships and Single-Member LLCs: Owner's Draw Only

If you're operating as a sole proprietor or single-member LLC (taxed as a disregarded entity), you can't technically pay yourself a salary. Here's why: the IRS doesn't consider you an employee of your own business. Your business income flows directly to your personal tax return on Schedule C.

How it works:

• Take draws whenever you need money

• No payroll taxes are withheld

• Pay self-employment tax (15.3%) on your net business income when you file your tax return

• Your draws don't affect your taxable income—you're taxed on profits, not on what you withdraw

Example: Maria runs a marketing consulting LLC taxed as a sole proprietorship. In 2024, her business earned $120,000 in net profit. She took $90,000 in draws throughout the year for living expenses. Come tax time, she'll pay income tax and self-employment tax on the full $120,000, regardless of how much she withdrew.

Partnerships and Multi-Member LLCs: Guaranteed Payments and Draws

Partnerships and multi-member LLCs (taxed as partnerships) use a hybrid approach. Partners typically receive:

Guaranteed Payments: Regular compensation for services rendered, similar to a salary but not subject to payroll tax withholding. These are deductible business expenses.

Distributive Share/Draws: Your portion of remaining profits based on your ownership percentage.

How it works:

• Guaranteed payments are reported on Schedule K-1

• Partners pay self-employment tax on guaranteed payments plus their distributive share

• Draws beyond guaranteed payments reduce your capital account

Example: Tom and Lisa own a 50/50 construction LLC. They each take $60,000 in guaranteed payments. The business also generates $80,000 in additional profit. Each partner reports $100,000 on their personal return ($60,000 guaranteed payment + $40,000 distributive share) and pays self-employment tax on that full amount, even if they didn't take all $40,000 in cash.

S-Corporations: Reasonable Salary Required, Then Distributions

This is where it gets strategic. S-Corp owners must pay themselves a reasonable salary through payroll before taking any distributions. This is an IRS requirement, not a suggestion.

How it works:

• Pay yourself a W-2 salary with normal payroll tax withholding

• Take additional compensation as distributions, which avoid the 15.3% self-employment tax

• Salary must be "reasonable" for your role and industry

The tax advantage: Distributions from an S-Corp aren't subject to the 15.3% self-employment tax (though they are subject to income tax). This is the main reason many profitable small businesses elect S-Corp status.

Example: David runs a pressure washing S-Corp that nets $150,000 annually. He pays himself a $70,000 salary (comparable to what he'd pay a manager to run operations). The remaining $80,000 he takes as distributions.

The savings: If David were a sole proprietor, he'd pay roughly $22,950 in self-employment tax on the full $150,000. As an S-Corp owner, he only pays the 7.65% employer and 7.65% employee portion (15.3% total) on his $70,000 salary—about $10,710. That's over $12,000 in tax savings, even after accounting for payroll processing costs.

Important caveat: The IRS scrutinizes S-Corps that pay artificially low salaries to maximize distributions. Your salary should reflect industry standards for your role. Paying yourself $30,000 when comparable business owners earn $80,000 is asking for an audit.

Important caveat: Additionally, Tennessee business owners should factor in the state's 6.5% franchise and excise tax on S-Corp income when evaluating the benefits. While you'll save on self-employment taxes through distributions, you'll pay Tennessee's corporate tax on your profits. This means the break-even point for S-Corp benefits is higher in Tennessee than in states without corporate income taxes—typically requiring $100,000+ in annual profit to see meaningful net savings after accounting for both payroll processing costs and state tax obligations.

Quick Reference Chart

Making the Right Choice for Your Business

Consider an S-Corp election if:

• Your business consistently generates $100,000+ in annual profit (note: Tennessee's 6.5% franchise and excise tax on S-Corps means you need higher profits to see real savings)

• You can justify and afford a reasonable salary

• You want to reduce self-employment taxes on distributions

• You're comfortable with additional payroll compliance requirements

Stick with owner's draws if:

• Your income is unpredictable or seasonal

• Your business is relatively new or low-profit

• You want simplicity over tax optimization

• Payroll processing costs would eat into any tax savings

Common Mistakes to Avoid

Mixing personal and business expenses: Whether you take a draw or salary, keep business and personal funds separate. Commingling funds creates bookkeeping nightmares and can jeopardize liability protection.

Ignoring quarterly estimates: If you're taking draws, remember you're responsible for quarterly estimated tax payments. Don't get caught with a massive tax bill in April.

Paying too little salary in an S-Corp: The IRS will reclassify distributions as salary and hit you with penalties and back payroll taxes. When in doubt, err on the side of a higher salary.

Not adjusting as you grow: What worked when you were making $50,000 might not make sense at $200,000. Revisit your compensation strategy as your business scales.

The Bottom Line

How you pay yourself isn't just about getting money in your pocket—it's a strategic decision that affects your taxes, your business's financial health, and your long-term wealth building. The right answer depends on your entity structure, income level, and business goals.

If you're unsure whether your current approach is optimized for your situation, it's worth having a conversation with a tax professional. A small adjustment now could save you thousands in taxes and set you up for smarter financial management as your business grows.

Related Posts

Getting your compensation strategy right is just one piece of smart financial management. These guides can help:

→ Year-End Financial Prep for Small Business: Checklist & When to Hire Help

Planning your compensation for next year? Start with clean books and a clear financial picture from year-end prep.

→ How to Improve Cash Flow Management for Small Business

Understanding how owner's draws and salary affect your cash flow helps you pay yourself consistently without stressing the business.

→ Chart of Accounts Explained: The Blueprint of Your Business Finances

Proper account structure ensures your owner's draw and salary are tracked correctly for tax reporting and financial clarity.

→ Bookkeeping vs. Accounting: What's the Difference for Small Businesses?

Strategic tax planning around S-Corp elections and compensation requires more than bookkeeping—it requires an accounting partner.

Ready to optimize how you pay yourself?

At Bottomline Capital, we help small business owners structure their compensation to minimize taxes and maximize cash flow. Whether you're considering an S-Corp election or want to make sure your current approach is optimized, we can help you navigate the options.

📅 Book a Free Consultation to discuss your entity structure and compensation strategy before year-end.