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What is the most tax efficient way to pay yourself as a business owner?

If you don’t feel like working for somebody else, you can start your own business. Being your own boss is an opportunity that attracts a large number of people. When you own a business company, you can make some profits that would go towards covering your everyday household expenses. If your business is successful, you can even put some money aside for a rainy day or for a holiday somewhere in Hawaii. But how do you pay yourself as a business owner to avoid paying too much in taxes? This depends on the type of the business company that you own.

Paying yourself out of business

Various types of company ownership structures are available to those wishing to engage in business on their own instead of holding a salaried position. Registering a sole proprietorship is extremely easy in terms of the bureaucratic procedures and this is probably the biggest advantage of this business ownership type. However, a sole proprietorship would not help you save on taxes very much. Whatever income your business makes, it is considered a personal income and the personal income tax is higher than the corporate tax in most cases. Please also bear in mind that if you engage in business and earn profits on your own without registering a company of any type, you will automatically be considered a sole proprietor and taxed accordingly.

Working as a sole proprietor is convenient in terms of paperwork but your liability will be unlimited and you won’t have much flexibility as far as taxes are concerned. On the other hand, if you establish a business with a more complex ownership structure, you may be able to protect your personal assets in a more efficient way and besides you will have more ways to pay yourself from your own business. The wider choice of payment options will give you a wider range of opportunities for tax maneuvers.

If you set up a Limited Liability Company (LLC), you will separate your personal possessions from the business assets and this is already a big plus. In addition to that, you can pay yourself in different ways. First, you can use the owner’s draw, which is a payment method highly popular with startups and small-scale business owners. We would like to note that not only the owners of LLCs can make owner’s draws but sole proprietorship as well as partnerships are allowed to do so too. Second, you can pay yourself a salary as your own company employee and your salary will count as part of the business expenses. Sole proprietors and partners in a partnership will rarely pay themselves salaries.

Make owner’s draws to pay yourself

What are the advantages of an owner’s draw? If you have just launched your business and/ or your cash inflow is unstable, you can adjust the amounts of money that you draw. When your business makes a hefty profit, you can draw more and when your business is slow, you can draw less. That is to say, the owner’s draw gives you enough flexibility. This may be especially important if the amount of money that your business makes depends on the season of the year. Besides, if you draw cash from your own LLC, then no tax is payable on the draw because the LLC is a pass-through business entity. Owner’s draws are considered fund transfers rather than wages or personal income so you are not taxed when you make an owner’s draw from your business. You will be taxed only when you report your personal income.  

What are the disadvantages of an owner’s draw? First, the business profits that you use to cover your personal expenses do not get reinvested in your company and the process of growing your business inevitably slows down when you make owner’s draws. Second, you can overdraw if you are not careful, which may hurt your business badly. Suppose you expect to sign a good business contract soon and make a draw based on the expectation. If you suddenly lose the contract, your business might have not enough operational funds. Striking a balance between personal and business expenditures requires careful bookkeeping and tax planning. Finally, if you own a C Corporation, you may have to pay the tax twice: first at the corporate level and then at the personal level.


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Pay yourself a salary

What are the advantages of a salary that you pay to yourself if you are a business owner? C Corp and S Corp owners often choose this method of paying themselves because it’s the simplest way to pay, first of all. When your business company pays you a fixed amount at regular intervals, it’s easy to keep the records and do the budgeting. Besides, your payroll tax will be deducted automatically. Paying yourself a salary is certainly an option to consider if your business makes stable profits. As far as LLCs are concerned, you don’t have to pay yourself a salary if your business company has this ownership structure but you can do so if you wish.  

What are the disadvantages of a salary that you pay to yourself as a business owner? You probably don’t want to pay yourself a salary if your business company income fluctuates greatly. If bad comes to worse and your company’s income is low, you might have no money to pay yourself a salary. Besides, avoiding double taxation is difficult if you opt for this method of paying yourself. First, the payroll tax is due (payable by your business company) and second, the personal income tax is due because salaries as well as dividends qualify as personal income.

Pay yourself dividends

One more way to pay yourself as a business owner is through dividends. This may be an especially good idea if you have a C Corp or an S Corp. Corporations often distribute their profits by paying dividends to their shareholders. If you are the owner of a business corporation, you can pay dividends to your own self. Perhaps, you could also think about combining these two methods of payment: pay yourself and salary plus distribute some more money to yourself through dividends. Such a combination may be worth considering in view of the ‘reasonable compensation’ requirement that is applicable to salaries paid by S Corporations. You cannot pay yourself too high a salary: it has to be commensurable with the salaries paid in the industry for similar services.

The ‘reasonable compensation’ requirement does not apply to C Corporations, however. It is true that C Corp owners are taxed twice: they pay a tax on their business companies’ profits and then they pay a tax on their personal incomes. But then again, your salary can be deducted from your business company’s taxable income, which will lower your corporate tax bill.

Be flexible about paying yourself

So how should you pay yourself in the most tax efficient way if you own a business? If you are engaged in a small-scale business and you operate as a sole proprietor, making owner’s draws is the most natural way to pay yourself. Strike a business deal, make a profit, and take home a certain part of it. A sole proprietorship is the simplest company type to run but this business ownership structure disallows using some methods of saving on taxes that are available to LLC and Corporation owners.

Without doubt, setting up an LLC or a Corporation takes more time and more paperwork in comparison to registering a sole proprietorship but it makes you more flexible when it comes to paying yourself. There are three main ways to pay yourself if you are a business company owner: by making owner’s draws, by paying yourself a salary, or by distributing dividends to yourself. Theoretically, you could also pay yourself as an independent contractor but this payment method is not going to be tax efficient.

Why not combine all the three payment methods if it can bring you some tax benefits? We cannot deny that hard analytical work is required if you are to figure out how you can best save on taxes being a business owner. You have to sit down with the accounting records, study the tax legislation very carefully and try to determine how you can pay yourself in the most tax efficient manner. Applying for professional assistance is recommendable here because the amount that you will be able to save on taxes is probably going to be higher that the fee you’ll have to pay to the tax lawyer or tax accountant. 

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