- Owner’s draw or salary: How to pay yourself
- Step #1: Understand the difference between salary vs. draw
- Step #2: Understand how business classification impacts your decision
- Step #3: Understand how owner’s equity factors into your decision
- Step #4: Understand tax and compliance implications
- Step #5: Determine how much to pay yourself
- Step #6: Choose salary vs. draw to pay yourself
- Understanding the difference between an owner’s draw and a salary
- What is a salary?
- Business taxations to consider
- Understanding owner’s equity
- Paying yourself by business type or classification
- Other considerations for paying yourself as a business owner
- How to determine how much to pay yourself as a business owner
- Which method is right for you? Salary vs. draw
- Pay yourself the right way
Owner’s draw or salary: How to pay yourself
Step #1: Understand the difference between salary vs. draw
- Owner’s draw: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals, or when needed.
- Salary: The business owner determines a set wage or amount of money for themselves, and then cuts a paycheck for themselves every pay period.
Step #2: Understand how business classification impacts your decision
- C Corporation (C Corp)
- S Corporation (S Corp)
- Sole Proprietorship
- Limited Liability Company (LLC)
Step #3: Understand how owner’s equity factors into your decision
Step #4: Understand tax and compliance implications
- C Corporations: C Corps are subject to double taxation. The C Corp files a tax return and pays taxes on net income (profit).
- Pass-through entities: Generally, all other business structures pass the company profits and losses directly to the owners. That’s why they’re referred to as pass-through entities.
Step #5: Determine how much to pay yourself
- Business structure
- Business performance
- Business growth
- Reasonable compensation
- Personal needs
Step #6: Choose salary vs. draw to pay yourself
Understanding the difference between an owner’s draw and a salary
What is an owner’s draw?
Pros and cons of an owner’s draw
- Greater flexibility: Rather than needing to pay herself a set amount, Patty’s compensation can fluctuate depending on how her business is performing.
- Reduced funds: An owner’s draw reduces a business’s equity, which reduces the funds available for future business spending.
What is a salary?
Pros and cons of a salary
- Less admin work: Taxes are deducted from your paycheck automatically. Additionally, your compensation as the business owner is a more stable expense, which makes it easier to track your income and expenses.
- Cash flow: What happens if your business has a down month? While it’s possible to adjust your salary to give yourself some more wiggle room, your salary still needs to fall within the IRS’ definition of reasonable compensation. Plus, figuring out how much to pay yourself can be challenging.
Business taxations to consider
- Corporations: The C Corp files a tax return and pays taxes on net income (profit). The owners can retain the after-tax earnings for use in the business, or pay shareholders a cash dividend. If a dividend is paid, the dividend income is added to other sources of income on the shareholder’s personal tax return.
- Pass-through entities: Generally, all other business structures pass the company profits and losses directly to the owners. Sole proprietorships, partnerships, S Corps, and several other businesses are referred to as pass-through entities. Assume, for example, that Patty’s catering business is a partnership and her share of the income is $10,000. The partnership would file a tax return and issue her a Schedule K-1, which reports the $10,000 in income. The $10,000 is then reported on her personal tax return as income from her partnership. The partnership tax return documents the partners, the percentages of ownership, and the partnership’s profit—but no taxes are actually calculated on the partnership tax return.
Understanding owner’s equity
Assets — liabilities = equity
Paying yourself by business type or classification
Paying yourself as a sole proprietor
Paying yourself in a partnership
Paying yourself from a Limited Liability Company (LLC)
Paying yourself as an S Corp
Paying yourself from a corporation
Other considerations for paying yourself as a business owner
Social Security and Medicare taxes
Risks of taking large draws
Avoiding tax confusion
How to determine how much to pay yourself as a business owner
- Business structure: Your business entity impacts a lot of your decisions. Many entities don’t allow you to take a salary, meaning you’ll need to take an owner’s draw.
- Business performance: Regardless of which way you choose to pay yourself, it’s important to remember that your compensation as the business owner isn’t set in stone. You can make some changes as you consider your business’s performance. You should only pay yourself from your profits and not overall revenue. So, if your business is doing well, you might be able to increase your compensation.
- Business growth: While performance is an important consideration, so is the current stage of your business. For example, if your business is a relatively new startup and in a stage of high growth, you’ll likely want to reinvest a lot of the profits back into the business, rather than pocketing them as compensation for yourself.
- Reasonable compensation: Only taking a $10,000 salary from your company each year is going to raise some red flags with the IRS. Make sure you familiarize yourself with the IRS’ guidelines and ask around to figure out what a reasonable salary for your type of work is.
- Personal expenses: That reasonable compensation will give you a starting point, but it doesn’t need to be your only answer. You have personal expenses—from your mortgage or rent to your savings account—that you need to fund. Get a good grasp on what those expenses are, so you can make sure you’re taking home enough to cover them.
Which method is right for you? Salary vs. draw
- Business funding: You need to leave enough capital in the business to operate, so consider that before you take a draw.
- Tax liability: A business owner needs to be very clear about the tax liability incurred, whether the distribution is a salary or a draw. Work with a CPA to plan for your tax liability and any required estimated payments.
- Each method generates a tax bill: You’ll pay Social Security, Medicare, and income taxes through each type of business entity. Your decision about a salary or owner’s draw should be based on the capital your business needs and your ability to perform accurate tax planning.
Pay yourself the right way
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