How to Pay Yourself as a Business Owner: Salary vs. Owner's Draw Explained

Most people start a business to make money -- but surprisingly few business owners know the best way to actually pay themselves. Should you take a fixed salary? An owner's draw? Some combination of both? The answer depends on your business structure, tax strategy, and growth plans -- and getting it wrong can trigger IRS scrutiny or cost you thousands in unnecessary taxes.

According to recent data, the average small business owner in the United States earns roughly $128,000 per year. But that number hides enormous variation. Some owners take home nothing for months while reinvesting in growth, while others inadvertently overpay themselves and starve their business of working capital.

Here is what you need to know about paying yourself the right way.

The Two Main Methods: Salary vs. Owner's Draw

There are two fundamental approaches to taking money out of your business for personal use.

Owner's Draw

An owner's draw is when you withdraw money directly from your business profits. You decide the amount and timing. Draws reduce your ownership equity in the business -- think of it as taking money out of an account you own.

Key characteristics of an owner's draw:

• No taxes are withheld at the time of withdrawal
• You are responsible for paying federal, state, and local taxes yourself
• You must make quarterly estimated tax payments to avoid penalties
• The amount can vary based on business performance

Salary (W-2 Compensation)

A salary means paying yourself a fixed amount at regular intervals, just like any other employee. Your business withholds income taxes, Social Security, and Medicare from each paycheck and sends those payments to the IRS on your behalf.

Key characteristics of a salary:

• Taxes are automatically withheld from each paycheck
• Provides predictable personal income
• Creates a deductible business expense
• Must meet "reasonable compensation" standards set by the IRS

How Your Business Structure Determines Your Options

Your legal entity type dictates which compensation methods are available -- and in some cases, which are required.

Sole Proprietorship

If you operate as a sole proprietor, an owner's draw is your only option. The IRS does not distinguish between you and your business, so there is no mechanism for paying yourself a formal salary. All net business income flows through to your personal tax return, and you pay self-employment tax (15.3%) on the full amount regardless of how much you actually withdraw.

Partnership or Multi-Member LLC

Partners and LLC members typically take guaranteed payments or distributions. The partnership itself does not pay income tax -- instead, each partner reports their share of profits on their personal return based on the partnership agreement. Self-employment tax applies to guaranteed payments and each partner's distributive share of trade or business income.

S Corporation

S Corporations offer the most flexibility and the greatest tax-planning opportunity. If you actively work in the business, the IRS requires you to pay yourself a "reasonable salary" through payroll. After satisfying that requirement, you can take additional profits as distributions, which are not subject to self-employment tax.

This is where the real savings potential lies. An S Corp owner earning $150,000 who pays a $90,000 salary and takes $60,000 in distributions could save roughly $9,000 in self-employment taxes compared to operating as a sole proprietor.

C Corporation

C Corporation owner-employees must receive all compensation through payroll as W-2 wages. Owner's draws are not available. Any profits distributed as dividends face double taxation -- first at the corporate rate (21% federal), then again on the shareholder's personal return at the qualified dividend rate (typically 15-20%).

Understanding Reasonable Compensation

If your business structure requires a salary, the IRS expects it to be "reasonable." This means the amount should reflect what you would pay an unrelated employee to perform the same work under similar circumstances.

The IRS examines several factors when evaluating whether compensation is reasonable:

• Training and experience you bring to the role
• Duties and responsibilities you perform
• Time and effort you devote to the business
• Comparable salaries for similar positions in your industry and geographic area
• Business size and complexity, including gross receipts
• Company profitability and your role in generating that profit

The 60/40 Rule Is a Myth

You may have heard that you should split your income 60% salary and 40% distributions. This is not an IRS-approved formula. No fixed ratio exists. Your compensation must be based on market data and your specific circumstances, not arbitrary percentages. Using a fixed ratio without supporting documentation could fail an IRS audit.

Real-World Consequences of Getting It Wrong

The IRS actively scrutinizes owner compensation, and the consequences of missteps can be significant.

Paying Yourself Too Little (S Corp Risk)

In the well-known case Watson v. United States, a CPA in Iowa paid himself just $24,000 annually while his firm generated over $200,000 in profits. He took the remaining $220,000 as distributions to avoid payroll taxes. The court found his salary "laughably inadequate" and reclassified $151,000 as wages, resulting in back payroll taxes, penalties, and years of legal fees.

In another case, an Arkansas accountant took $83,000 in distributions without paying himself any salary at all. The IRS successfully argued that someone performing substantial services cannot work for free and established a reasonable salary between $45,000 and $49,000.

A business earning $500,000 that pays its owner-operator $40,000 is practically inviting an audit.

Paying Yourself Too Much (C Corp Risk)

C Corporation owners sometimes inflate their salaries because wages are tax-deductible, reducing the company's taxable income. If the IRS determines compensation is excessive, it can reclassify the excess as non-deductible dividends, increasing the corporation's tax bill and potentially triggering penalties.

How to Determine the Right Amount

Follow these steps to establish a defensible compensation amount.

Step 1: Research Market Data

Use objective sources to benchmark salaries for your role:

• Bureau of Labor Statistics (BLS.gov) provides official government salary data by occupation and location
• Industry associations often publish annual compensation surveys
• Job postings from competitors reveal current market rates
• Online salary databases like Glassdoor or Payscale offer additional data points

Step 2: Account for All the Hats You Wear

Most small business owners perform multiple roles -- CEO, bookkeeper, sales manager, customer service representative, and more. Your compensation should reflect the value of all those roles combined, not just one title.

List every function you perform and research the market rate for each. Weight them by the percentage of time you spend on each role, then aggregate to arrive at a total compensation figure.

Step 3: Consider Your Business Finances

Your salary should be sustainable for the business. General guidelines suggest:

• Solo service businesses: 40-50% of revenue as owner compensation
• Small retail: 30-40% of revenue
• Restaurants: 25-35% of revenue
• SaaS or digital businesses: 50% or more of revenue

Always maintain 3-6 months of operating expenses as a cash reserve before determining your take-home pay.

Step 4: Document Everything

Keep records of how you determined your compensation amount. Save salary surveys, market research, board meeting minutes approving compensation, and any professional advice you received. The IRS audit window extends up to six years, so retain this documentation accordingly.

Tax Planning Strategies for 2026

Several tax considerations are especially relevant this year.

Social Security Wage Base

For 2026, the Social Security wage base is $184,500, up from $176,100 in 2025. You pay the 12.4% Social Security tax only on wages up to this threshold. Medicare tax (2.9%) applies to all income with no cap, and high earners above $200,000 (single) or $250,000 (married filing jointly) pay an additional 0.9% Medicare surtax.

Qualified Business Income (QBI) Deduction

The Section 199A deduction allows eligible business owners to deduct up to 20% of their qualified business income. For S Corp owners, this creates an interesting interplay with salary decisions.

If your income is below the QBI threshold ($203,000 single or $406,000 married filing jointly), you need to balance the additional payroll tax cost of a higher salary against the QBI deduction benefit. In some cases, a higher salary actually generates more QBI savings than the additional FICA cost -- for example, an extra $60,000 in salary might cost approximately $6,900 in additional FICA but generate roughly $9,900 in QBI savings.

Self-Employment Tax Deduction

If you are self-employed, you can deduct the employer-equivalent portion of your self-employment tax (half of 15.3%) as an above-the-line deduction on your personal return. This reduces your adjusted gross income and your overall tax burden.

Five Common Mistakes to Avoid

1. Not paying yourself at all. Some owners reinvest everything back into the business for years. While this can make sense during startup, it creates problems with the IRS if you are required to take a salary and makes personal financial planning nearly impossible.

2. Ignoring the reasonable compensation requirement. If you operate an S Corp or C Corp, reasonable compensation is not optional. The IRS can reclassify distributions as wages, assess back taxes with interest, and impose penalties of 20-40%.

3. Using arbitrary ratios. Basing your pay on a fixed percentage rather than market data and documented analysis leaves you vulnerable in an audit.

4. Failing to adjust annually. Your compensation should evolve as your business grows, your responsibilities change, and market rates shift. Review and update your salary determination at least once per year.

5. Mixing personal and business finances. Regardless of how you pay yourself, maintain separate business and personal bank accounts. Commingling funds makes bookkeeping difficult, complicates tax preparation, and can undermine the liability protection of your business entity.

When to Consider Changing Your Business Structure

If you are currently operating as a sole proprietor and your net business income consistently exceeds $60,000-$80,000 per year, it may be worth evaluating whether an S Corporation election could reduce your tax burden. The payroll tax savings on distributions can be substantial, though you will need to factor in the additional costs of payroll processing, corporate tax filings, and compliance requirements.

Consult with a tax professional who can model the specific numbers for your situation before making any structural changes.

Keep Your Finances Organized from Day One

However you choose to compensate yourself, maintaining clear and accurate financial records is essential. Proper bookkeeping makes it easy to track owner draws, document salary decisions, and prepare for tax season without scrambling for numbers. Beancount.io provides plain-text accounting that gives you complete transparency and control over your financial data -- no black boxes, no vendor lock-in. Get started for free and see why developers and finance professionals are switching to plain-text accounting.