Small Business Owners: Should You Take a Pay Check or a Draw?

Small business owners frequently ask us for advice on the best way to draw money for personal expenses from their business.  After all, they are working to produce a living and they need to insure that their state and local income and social security tax liabilities are covered. 

The best method depends on the structure of the business:

Sole Proprietors and Partners are not considered employees of their businesses.  Therefore,they can save themselves the expense of using a payroll service by taking draws for personal expenses, rather than receiving a pay check.  Net earnings of sole proprietorships and partnerships “pass through” to the owners whether or not such draws are taken; consequently, income tax and self-employment tax (social security and Medicare) must be paid on the estimated net earnings by making quarterly tax deposits using Form 1040ES.  If the sole proprietorship or partnership has non-owner employees a payroll service can be used to pay compensation to the employees for hours worked. 

Owners/Shareholders of S Corps who work for the company are considered employees of the corporation and should be paid through payroll and have income and social security taxes withheld.  Owners should receive a "reasonable salary" for their work and will need to pay income and social security tax on the salary via regular payroll tax deposits.  These owner salaries are deducted as an expenses of the corporation and the remaining net income of the company “passes through” to individual shareholderss based upon their ownership percentage.  Income that passes through in this manner is taxable for income tax purposes, but is not taxed for social security purposes. 

In summary:
Sole Proprietorship
Draw, Income and Social Security Taxes on Net Income via Quarterly Deposits

Partnership
Draw, Income and Social Security Taxes on Net Income via Quarterly Deposits

S Corp
Payroll, Income and Social Security Tax on “Reasonable” Salary, plus income tax on remaining “Pass Through” net income.