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Can Business Owners Be Paid Through Payroll?

Whether a business owner can-or must-be paid through payroll depends entirely on the business’s tax structure. In some entities, payroll is required for owners who perform services. In others, payroll is not permitted at all. This distinction matters because payroll triggers withholding, payroll taxes, reporting obligations, and audit risk.

This article explains:

• Which owners must use payroll (and which cannot)
• How owner compensation is taxed
• How to determine a reasonable salary for S-corporation owners
• How payroll withholding can be used to cover income taxes on owner distributions and avoid quarterly estimated payments
• Practical examples tying everything together

Paying Yourself Through Payroll by Entity Type

Sole Proprietors

Payroll allowed? No

Sole proprietors cannot pay themselves wages. The IRS treats the owner and the business as the same taxpayer.

How owners are paid

• Owner draws

Tax treatment

• Net profit is subject to:
  • Federal and state income tax
  • Self-employment tax (Social Security and Medicare)

Because no withholding occurs, most sole proprietors must make quarterly estimated tax payments unless they have sufficient withholding from other sources, such as a spouse’s W-2 income.

Partnerships and Multi-Member LLCs (Taxed as Partnerships)

Payroll allowed for owners? No

Partners are not employees and cannot receive W-2 wages for ownership services.

How owners are paid

• Distributions
• Guaranteed payments

Tax treatment

• Income reported on Schedule K-1
• Subject to income tax
• Generally subject to self-employment tax for active partners

As with sole proprietors, estimated tax payments are usually required unless taxes are covered through other withholding.

S Corporations

Payroll required? Yes, for active owners

Any S-corporation owner who provides services to the business must be paid a reasonable salary through payroll.

How owners are paid

1. W-2 wages (required)
2. Distributions (optional)

Tax treatment

• Wages:
  • Subject to income tax withholding
  • Subject to Social Security and Medicare taxes
• Distributions:
  • Subject to income tax
  • Not subject to payroll taxes

The IRS closely scrutinizes S-corporation compensation because underpaying wages reduces payroll tax liability.

C Corporations

Payroll required? Yes, for working owners

Owners who perform services must be paid wages like any other employee.

How owners are paid

• W-2 wages
• Dividends (optional)

Tax treatment

• Wages:
  • Deductible by the corporation
  • Subject to payroll and income tax withholding
• Dividends:
  • Not deductible
  • Taxed again at the shareholder level

How to Determine a Reasonable Salary for S-Corporation Owners

The IRS does not provide a fixed formula for reasonable compensation. Instead, audits and court cases consistently focus on market-based compensation for services actually performed.

Key factors the IRS considers:

• Duties and responsibilities
• Time spent working in the business
• Industry norms
• Geographic location
• Company size and profitability
• Training, certifications, and experience
• What the business would pay a non-owner to do the same job

Ownership percentage alone is not a determining factor. We strongly recommend documenting how the reasonable salary was determined in case of audit.

Practical Framework for Setting a Reasonable Salary

Step 1: Identify the Owner’s Role

• Sales
• Management
• Technical work
• Client service
• Administrative duties

If the owner performs multiple roles, consider blended compensation.

Step 2: Research Market Wages

• Bureau of Labor Statistics (BLS)
• Industry salary surveys
• Job postings for comparable roles

Focus on gross annual compensation, not hourly rates.

Step 3: Adjust for Time Worked

If the owner works part-time, adjust compensation proportionally.

Step 4: Pay Wages Before Distributions

Distributions should generally not exceed profits remaining after reasonable wages are paid.

Reasonable Salary Example

Facts

• S-corp net profit before owner pay: $160,000
• Owner works full-time as general manager
• Market salary range: $85,000–$105,000

Conclusion

A reasonable salary might be $95,000.

Result

• $95,000 paid through payroll
• $65,000 available for distributions

Using Payroll Withholding to Cover Taxes on Distributions

Distributions are taxable but have no automatic withholding, which often leads to underpayment issues. Owners can offset this by increasing payroll withholding.

The IRS treats payroll withholding as paid evenly throughout the year, even if it occurs later in the year. This allows owners to avoid quarterly estimated payments.

Example: Covering Federal Taxes Through Payroll Withholding

Facts

• S-corp owner salary: $95,000
• Distributions: $65,000
• Filing status: Married filing jointly
• Estimated marginal federal tax rate: 22%

Step 1: Estimate Tax on Distributions

$65,000 × 22% = $14,300

Step 2: Increase Payroll Withholding

If paid biweekly (26 pay periods):

• $14,300 ÷ 26 = $550 additional federal withholding per paycheck

Alternatively, the owner could add a flat amount per paycheck or run a year-end bonus payroll with increased withholding.

Safe Harbor Rules and Withholding Strategy

To avoid underpayment penalties, taxpayers generally must pay:

• At least 90% of current-year tax, or
• 100% of prior-year tax (110% for higher-income households)

Payroll withholding counts fully toward these thresholds.

Example: Avoiding Estimated Payments

Prior-year tax: $28,000
Current-year projected tax: $30,500

If payroll withholding reaches $28,000, the safe harbor is met and no estimated payments are required.

Key Takeaways

• Owner payroll rules depend on entity structure.
• S-corp and C-corp owners who work in the business must receive wages.
• Reasonable salary is based on market value for services performed.
• Distributions are taxable even though no withholding occurs.
• Increasing payroll withholding can replace quarterly estimated payments.
• Proper planning reduces audit risk and prevents unexpected tax bills.