How Should I Be Paying Myself? A Guide to Compensation for Business Owners

Key Takeaways:

• Without a clear compensation strategy, business owners may put their business and personal finances at risk. Instead, entrepreneurs should pay themselves using a consistent, intentional system so they can maintain a sustainable income without compromising their future.
• Calculating the right salary involves considering the owner’s living wage floor, taxes, replacement cost of their role, reasonable compensation rules, and more.
• An owner’s compensation strategy should evolve alongside the business, adapting with revenue growth, changes in their role and responsibilities, their goals, and more.

As entrepreneurs who specialize in financial planning for business owners, we’ve observed that many lack a clear compensation strategy, ranging from paying themselves inconsistently or last to blurring the personal and professional lines of their finances. These decisions often occur early in the startup phase and can become detrimental habits if left unchecked. Underpaying yourself can cause personal financial stress, while taking too much from the business can hinder cash flow, affecting future growth, hiring, and taxes.

We suggest business owners steer away from these ends of the spectrum and create sustainable income in the middle that balances today’s lifestyle needs with their future plans for themselves and the company. By understanding how your compensation affects your taxes, retirement savings, and business cash flow at every stage of growth, you can build a repeatable system that helps you confidently take income without compromising your business. 

What Is Your Business Entity? Payment by Business Structure & Tax Considerations

Finding the right approach to paying yourself depends on factors such as your entity type, IRS requirements, and goals. As you consider how to pay yourself, a useful starting point is understanding how business owners are typically paid based on their business structure, as each comes with different rules and tax treatment. Below is a reference you can use to learn how compensation is taxed based on entity type. This table is a general overview of federal taxes; state tax rules and entity-specific details may vary.

Guidelines: Setting the Right Salary Amount

Once you understand the implications your business structure may have on how you pay yourself, you can turn to your unique situation. Everyone’s lifestyle and expenses are different, but there are key factors you can consider when calculating your income. Here is a standard process business owners can follow to determine their right salary.

The Living Wage Floor: Your Minimum Viable Income

To establish your core income, you must first understand the difference between your needs and your wants. A living wage is the minimum income you need to support personal expenses, such as housing, groceries, taxes, childcare, and other fixed, non-negotiables. Also consider these baseline costs:

• Debt payments
• Personal taxes, such as state, federal, and estimated taxes
• Savings goals, such as retirement contributions and an emergency fund

“Wants” are costs for discretionary spending for non-essentials, such as travel upgrades or luxury goods. While a living wage covers your essentials, bonus distributions can help fund your wants — with consistency and stability being key.

Market Value Benchmarking: The Replacement Cost

Another question to consider when defining your salary is this: If you left tomorrow, how much would you have to pay someone to do what you do every day, or what is the market replacement cost? This again helps make decision-making more objective and focused on market value for the role or roles you perform, rather than just taking what’s left over or being led by guilt or sacrifice.

The Percentage Method: Rules of Thumb

Another common method is to pay yourself a percentage of revenue or profit. Defining that percentage will depend on your living wage floor as well as seasonal fluctuations, growth plans, hiring needs, and other factors.

The percentage method may vary for different industries. A professional services firm, restaurant, and construction company may have very different profit margins, so what is reasonable for one industry may not work for another.

Additionally, most business owners receive income, pay their bills, and then pay themselves rather than prioritizing their compensation. However, the Profit First method, introduced by Mike Michalowicz, allocates income to respective expenses, such as operations, owner pay, and taxes.¹ 

Example allocations may look like 40% to operating costs, 30% to owner compensation, 15% to taxes, and so on. These categories can help you better understand your resources and what your business can afford.

The Reasonable Compensation Standard

Before taking profit distributions, particularly as a business owner of an S corp, consider whether your salary is reasonable compensation as defined by the IRS.² “Reasonable” refers to the market value of what someone in your comparable role would earn. If your income isn’t considered reasonable, your business could be flagged for potentially avoiding payroll taxes and audits. To mitigate this risk, maintain organized records of your defined role and responsibilities, market data, and a consistent compensation structure.

What Should the Business Be Able to Afford?

Your compensation should align with what your business needs to operate and grow without financial pressure. You can ask the following questions to help build a compensation strategy that provides stability and capital needed for planned and unplanned expenses:

• Can the business comfortably cover essential expenses, such as rent, vendor payments, taxes, and payroll?
• Does the business have sufficient cash reserves for emergencies and slower periods?
• Will increasing pay strain cash flow or limit hiring decisions?
• Does the business have enough set aside for taxes?

Additionally, you should consider invoice payments, inventory needs, debt payments, and other timing factors that may affect how much compensation your business can afford.

Choosing a Tax-Efficient and Compliant Payment Method: Draw vs. Salary vs. Distributions

There are three common payment methods business owners may consider, depending on their business structure, financial needs, and tax considerations: owner’s draw, a formal paycheck, or distributions. 

One of the most common questions we hear from business owners is what strategy allows them to keep the greatest share of the money they’ve worked so hard for. While looking for an approach that allows you to pay the lowest amount of taxes may seem like the best way to do that, it’s important to recognize that tax efficiency has a ceiling. 

The most effective compensation strategy is not necessarily the one with the lowest tax bill in a single year. A more sound approach is one that establishes the highest sustainable after-tax income over time. That means balancing salary, distributions, retirement contributions, entity structure, cash reserves, and audit risk. Keep that nuance in mind as you read on, and remember that your financial advisor and CPA can help you assess your unique situation.

Owner’s Draw 

This involves a transfer of funds from the business to the business owner, common in sole proprietorships, partnerships, and single-member LLCs. 

• Primary Benefit: A potential tax advantage is that payroll processing is not required, which may help reduce administrative costs and compliance requirements and increase flexibility.
  • Key Considerations: The owner is responsible for paying quarterly estimated taxes, which aren’t withheld automatically. Without a structured payroll, the owner must proactively manage budgeting, taxes, and cash flow.
• Guaranteed Payment: Similar to an owner’s draw, this is a payment for services rendered by partners who are not considered official employees of the business.

• Key Considerations: While still subject to self-employment taxes, payroll taxes are not automatically withheld. Payments must also align with partnership agreements and tax reporting requirements.

W-2 Paycheck

This is a formal paycheck the business owner receives. 

• Primary Benefit: A paycheck helps S corp owners stay compliant with reasonable compensation and may also make income and taxes more consistent and easier to plan.

• Key Considerations: Income is withheld for Medicare, Social Security, and income taxes. Payroll may increase administrative costs and compliance requirements, including the need to provide reasonable compensation.

Distributions (S Corp) and Dividends (C Corp)

Distributions (S Corp): These refer to additional payouts, in addition to salary, to a business owner. 

• Primary Benefit: S corp owners can help reduce tax exposure by splitting their compensation between a salary and distributions. 
  • Key Considerations: Distributions must also comply with reasonable compensation rules. These distributions are generally not subject to self-employment or payroll taxes, though the underlying business income still passes through to the shareholder’s personal tax return and must be planned for through withholding or estimated tax payments.

Dividends (C Corp): These are after-tax business profits that are distributed to shareholders in addition to a salary.

• Primary Benefit: C corp businesses may be eligible for a more favorable corporate tax rate.
  • Key Considerations: The business pays corporate tax, and then the shareholder pays taxes again on what they receive, a form of double taxation.

Evolution: Shifting Strategies Over Time

As your business evolves — from a startup to scalable growth — so will your compensation strategy.

The Growth Phase: Moving from Sole Proprietor to S Corp

With business growth and steady net profits, it may make financial sense for a sole proprietor to transition to an S corp. 

While an S corp has more administrative costs, from running payroll to more sophisticated bookkeeping, there comes a “tipping point” at which the tax savings may outweigh those overhead expenses. Many advisors begin evaluating an S corp election once a business produces steady profits above the owner’s reasonable compensation needs and administrative costs. For some owners, the break-even point may appear around a net profit between $50,000 and $75,000, but the right threshold depends on payroll costs, state taxes, bookkeeping expenses, retirement plan strategy, and the owner’s role.

Unlike salary payments, profit distributions are not subject to payroll taxes, which can result in significant savings. Keep in mind that S corp business owners are required to take formal W-2 paychecks rather than owner draws, process regular payroll, and comply with applicable entity requirements.

Reinvesting vs. Taking: Scrappy to Scaling

Similarly, as your business grows, your reinvestment approach may change. You may consider hiring more employees, increasing your take-home pay, or taking a bonus. Here are some things to evaluate:

• Should you increase your pay or hire your next employee? If your personal financial needs are met or you’ve noticed that growth or your current capacity can’t keep pace with demand, it may be time to hire another employee. Conversely, if you’re struggling personally or financial stress is affecting your ability to work or make decisions, it may be time to increase your pay. 
• Is reinvesting everything posing a risk? It’s common to reinvest in your business as you’re getting it off the ground. However, the situations listed above, as well as other indicators such as falling behind on payments, taxes, or retirement savings, may signal that it’s time to review your reinvestment approach. 
• How should bonuses evolve? Typically, early on, bonuses are minimal, if any, with many owners opting to reinvest profits. As your business grows, you may consider taking periodic, profit-based bonuses. At scaling businesses, business owners typically look at defined metrics and milestones, such as revenue targets, when considering a bonus.

Structural Shifts: The Long-Term View

You may find that over time, with growth, profitability, and even ownership changes, the legal entity you chose on day one may not support tax efficiency or you may consider integrating your income strategy with long-term estate planning. It may be time to rethink your entity type if:

• Significant changes in revenue are affecting your tax liability, for example, due to increased payroll taxes
• New tax laws affect your business’s tax efficiency or present additional planning opportunities
• You’ve added partners, employees, or services with certain compensation requirements

Changes to your legal entity, income, or tax situation may also prompt you to reevaluate your compensation. Some indicators may include:

• You may want to prioritize reinvestment over distributions during a growth phase
• Your responsibilities or role have shifted, affecting what constitutes reasonable compensation
• You’re unable to hire due to your salary or cash-flow constraints

Paying the Architect of the Legacy

Ultimately, business owners drive revenue through their time, decisions, and leadership. While paying yourself consistently can be a difficult transition for business owners, it ultimately helps you lead from a position of stability, make informed decisions, and plan ahead confidently.  

Lacking a clear compensation strategy, or over- or under-paying yourself, can pose a significant risk to you and your business, even if it appears financially strong on paper. This guide is an effective first step, but every business is different. We recommend consulting your CPA and financial advisor to run the numbers and develop a plan tailored to you. Contact us or view our business services to learn how to build a compensation strategy that’s efficient, compliant, and aligned with your goals.

Sources: 

1  Michalowicz, M. (2024, March 5). The Profit First Formula Explained. https://mikemichalowicz.com. https://mikemichalowicz.com/22811-2/. 

2 IRS. (2026, March 3). S corporation compensation and medical insurance issues. IRS.gov. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues#reasonable.

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