Paying yourself: salary, draw, dividend

In short

A friend of mine ran a small bakery for six years before anyone told her she was allowed to put herself on the payroll. If you own a business, you have probably wondered how to get money out of it without making a mess. How you take that money depends on how the business is set up. A sole proprietor takes a draw, an S corporation owner takes a salary plus distributions, and a C corporation pays salary and dividends. Each path is taxed in its own way. Ask what your business type allows before you write the first check. Keep business money and personal money apart. Then keep a record of every payment you make to yourself.

The whole of it

What it is

I once watched a plumber stand in his own garage, holding a shoebox of receipts, unsure whether the $2,000 he had pulled out that month counted as pay. It was a fair question, and a lot of good people ask it. Paying yourself means moving money from the business to your own pocket. There are three common ways to do it. A draw is money an owner takes out of a business that is not taxed separately from the owner. A salary is a regular wage paid through payroll, with taxes held back. A dividend is a share of profit that a corporation pays to its shareholders.

The word you use matters because the tax treatment differs. The IRS looks at how the business is organized first. Then it looks at what kind of payment you made. A sole proprietor or a partner in an LLC usually takes draws. An owner of an S corporation who works in the business must be paid a salary. After that, the owner can also take distributions of profit. A C corporation pays its owner a salary and can also pay dividends.

How it works

If you are holding a sole proprietorship, here is the plain truth. The business and you are one taxpayer. Your profit lands on your personal return whether you take it out or leave it in the account. The draw is just you moving your own money. It is not a deduction for the business, and no payroll taxes come out of it. Instead, you owe self employment tax on the profit itself. That tax covers Social Security and Medicare, and the IRS explains it on its page for the self employed.

An S corporation works differently. The owner who works in the company is an employee. The company must pay a reasonable salary for the work done, and it has to run payroll on that salary. That means withholding income tax and the employee share of Social Security and Medicare. The employer then pays its own share. After the salary is paid, any extra profit can come out as a distribution. Distributions are not hit with payroll tax. That is why the IRS watches the salary closely. It expects the pay to match what the job is worth.

A C corporation is its own taxpayer. It pays tax on its profit. Then, if it pays a dividend, the shareholder pays tax again on that dividend. People call this double taxation. The salary is a deduction for the company, but a dividend is not. So the owner weighs the two against each other.

The numbers, and where to find yours

I have learned that a number you cannot find is a number you will guess at, and guessing costs money. Some figures change each year, so the page will fill in the current ones. The Social Security wage base is the amount of earnings that Social Security tax applies to, and it is the current figure, which the official source publishes each year. The combined Social Security and Medicare rate for the self employed is the current figure, which the official source publishes each year. The tax rate on qualified dividends depends on your income, and the brackets are the current figure, which the official source publishes each year. The corporate income tax rate is the current figure, which the official source publishes each year.

You can find your own figures in a few places. Your business tax return shows your profit. Your payroll reports show the salary you have already paid. The IRS publishes the current rates and limits on its website, and Publication 334 covers small business taxes. Form 1120S is the S corporation return, and Form 1120 is the C corporation return. Your accountant can read them with you.

A worked example

Let me tell you about Marcus. He runs a small landscaping company as an S corporation. After paying all the bills, the business has $90,000 of profit for the year. Marcus does the work himself, so the company must pay him a reasonable wage. A local pay survey and his accountant suggest $50,000 for a job like his.

Marcus takes the $50,000 as salary through payroll. That leaves $90,000 minus $50,000, which is $40,000 of profit. He takes that $40,000 as a distribution. Payroll tax applies to the $50,000 salary only. The employee share of Social Security and Medicare is 7.65 percent of $50,000, which is $3,825. The company pays a matching $3,825 as the employer share. The $40,000 distribution carries no payroll tax.

Now picture the same profit in a sole proprietorship. All $90,000 is subject to self employment tax. Marcus's salary of $50,000 in the S corporation shields $40,000 from that tax. At the full self employment rate of 15.3 percent, $40,000 would carry $6,120 of tax. That is the gap that draws the IRS's attention, and it is why the salary has to be fair. If Marcus paid himself only $10,000 and took $80,000 as a distribution, the IRS could say the salary was too low. It could then reclassify the distribution as wages and bill him for the tax, plus penalties.

Notice what Marcus did right. He wrote down how he picked the $50,000. He ran payroll on schedule. He kept a separate business bank account. Those habits cost him very little.

Where it goes wrong

I would be a poor friend if I did not tell you where folks trip. The first mistake is mixing money. When a business account pays for groceries, the lines blur. They blur for the bank, and they blur for the IRS. Keep the accounts separate.

The second mistake is a salary that is too low. An S corporation owner may be tempted to pay a tiny wage and take the rest as a distribution. The IRS expects reasonable pay for the work done. It has said so in its guidance on S corporation compensation. A low salary invites trouble.

The third mistake is treating a draw like a paycheck with taxes already taken out. It is not. A sole proprietor has to pay estimated taxes during the year, using Form 1040-ES. Skip them, and a large bill and a penalty can arrive together.

The fourth mistake is paying a dividend the company cannot afford. State law limits dividends, and a corporation generally should not pay them out of money it does not have. Poor records make every one of these errors worse. A plain ledger saves a great deal of grief.

Questions to answer before you leave this page

What type of business do you own, and what does the IRS call it on your tax return? Do you know whether your owner pay should run through payroll or come out as a draw? If you own an S corporation, can you point to the reason your salary is the amount it is? Have you set aside money for estimated taxes, and do you know the due dates? Is your business bank account truly separate from your personal one? Who in your life, an accountant or an enrolled agent, can look at your numbers once a year and tell you plainly where you stand?