Salary vs. Draw: Pay Yourself as a Small Business Owner
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You love your business, but that doesn’t mean you can afford to work for free. Yet, figuring out how to pay yourself as a business owner can be complicated.
You need to think carefully about how you take money from your business entity. Typically, that’s done one of two ways: a salary or an owner’s draw.
Let’s compare salary and draw and discuss how to determine which is right for you and your business.
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Owner’s draw or salary: How to pay yourself
Some business owners pay a salary, while others compensate themselves with an owner’s draw. But how do you know which one (or both) is an option for your business? Follow these steps.
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Step #1: Understand the difference between salary vs. draw
You need to understand the basics before deciding which method is best for you. Here’s a high-level look at the difference between a salary and an owner’s draw (or simply, a draw):
- Owner’s draw: The business owner takes funds from 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.
Those are the nuts and bolts, but we’ll dig into even more details of salaries and draws in a later section.
Step #2: Understand how business classification impacts your decision
Many factors will influence your choice between a salary, draw, or another payment method (like dividends), but your business classification is the biggest one. The main types of business entities include:
- C Corporation (C Corp)
- S Corporation (S Corp)
- Sole Proprietorship
- Limited Liability Company (LLC)
- Partnership
Why does this matter? Different business structures have different rules for compensation for business owners. For example, if your business is a partnership, you can’t earn a salary because the IRS says you can’t be both a partner and an employee.
(An entire section below breaks down the different business classifications and the best way for each business owner to pay themselves.)
Step #3: Understand how owner’s equity factors into your decision
“Owner’s equity” is a term you’ll hear frequently when considering whether to take a salary or a draw from your business. Accountants define equity as the remaining value invested into a business after all liabilities have been deducted.
When you contribute cash, equipment, and assets to your business, you’re given equity—another term for ownership—in your business entity, which means you can take money out of the business each year.
Understanding your equity is important because if you choose to take a draw, your total draw can’t exceed your total owner’s equity.
Step #4: Understand tax and compliance implications
In addition to the different rules for how various business entities allow business owners to pay themselves, there are also various tax implications to consider.
With regard to taxes, C Corps are different from all other types of business entities. Here’s how:
- C Corporations: C Corps are subject to double taxation. The C Corp files a tax return and pays net income (profit) taxes.
- 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.
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Step #5: Determine how much to pay yourself
There’s a lot that goes into figuring out how to pay yourself. But here’s your next question: How much should you pay yourself?
There’s not one answer or formula that applies across the board. You’ll need to take the following factors into account:
- Business structure
- Business performance
- Business growth
- Reasonable compensation
- Personal needs
Step #6: Choose salary vs. draw to pay yourself
Once you’ve considered the above factors, you can determine whether to pay yourself with a salary, draw, or a combination of both.
You’ll also better understand how much compensation you’re realistically able to take out of your business.
Understanding the difference between an owner’s draw and a salary
We’ve covered the difference between an owner’s draw and a salary at a high level, but now let’s take a look at the nitty-gritty details of each, using an example: Patty, who is a sole proprietor and owns a catering company called Riverside Catering.
What is an owner’s draw?
An owner’s draw refers to taking funds out of the business for personal use. Many small business owners compensate themselves using a draw rather than a salary.
Patty could withdraw profits from her business or take out funds she previously contributed to her company. She may also use a combination of profits and capital from which she previously contributed.
Because Patty is a sole proprietor, all of the income earned by her business will appear on her personal tax return, and she’ll need to pay estimated tax payments and self-employment taxes on those earnings.
She doesn’t pay separate taxes on the owner’s draw because she’s simply taking out money that has been taxed in the past (which reduces equity) or money that will be taxed in the current year.
Pros and cons of an owner’s draw
Pro
- Greater flexibility: Rather than needing to pay herself a set amount, Patty’s compensation can fluctuate depending on how her business is performing.
Con
- Reduced funds: An owner’s draw reduces a business’s equity, which reduces the funds available for future business spending.
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What is a salary?
You probably already understand a salary: You get paid a set amount every pay period. It works similarly when you’re the business owner. You determine your reasonable compensation and give yourself a paycheck every pay period.
For example, maybe instead of being a sole proprietor, Patty set up Riverside Catering as an S Corp. She decided to give herself a salary of $50,000 out of her catering business. From there, she could do the math to determine what her paycheck should be given her current pay schedule.
Pros and cons of a salary
Pro
- 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.
Con
- Cash flow: What happens if your business goes down during the 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
Before making the owner’s draw vs. salary decision, you must form your business.
There are many ways to structure your company, and the best way to understand the differences is to consider C Corps vs. all other business structures:
- 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 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 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 calculated on the partnership tax return.
There are some exceptions, but generally, a business faces double taxation as a C Corp. If not, the company is a pass-through entity.
Understanding owner’s equity
Once you form a business, you’ll contribute cash, equipment, and other assets to the business. When you contribute assets, you are given equity (ownership) in the entity, and you may also take money out of the business each year. To make the salary vs. draw decision, you must understand the owner’s equity concept.
What’s equity? Simply put, it’s an accumulation of money not spent on the business or withdrawn over time for personal use. Equity is based on the balance sheet formula:
Assets — liabilities = equity
Assets are resources used in the business, such as cash, equipment, and inventory. Liabilities, on the other hand, are obligations owed by the business. Accounts payable, representing bills you must pay every month, are liability accounts, as are any long-term debts owed by the business.
If a company sells all its assets for cash and then uses the cash to pay all liabilities, the remaining cash is the firm’s equity.
Each owner can calculate his or her equity balance, and the owner’s equity balance may impact the salary vs. draw decision.
Paying yourself by business type or classification
Forgive us for sounding like a broken record, but the biggest thing you need to consider when figuring out how to pay yourself as a business owner is your business classification.
Why does this matter? Many business entities don’t allow you to take a salary. Let’s look at each type of business entity and how this impacts the salary vs. draw decision.
Paying yourself as a sole proprietor
Payment method: Owner’s draw
A sole proprietor’s equity balance is increased by capital contributions and business profits and is reduced by owner’s draws and business losses.
Let’s go back to Patty and her Riverside Catering business. In this example, Patty is a sole proprietor, and she contributed $50,000 when the business was formed at the beginning of the year. Riverside Catering posts this entry to record Patty’s capital contribution:
A normal balance for an equity account is a credit balance, so Patty’s owner equity account has a beginning balance of $50,000. During the year, Riverside Catering generates $30,000 in profits. Since Patty is the only owner, her owner’s equity account increases by $30,000 to $80,000. The $30,000 profit is also posted as income on Patty’s personal income tax return.
Patty can choose to take an owner’s draw at any time. She could take some or even all of her $80,000 owner’s equity balance out of the business, and the draw amount would reduce her equity balance. So, if she chose to draw $40,000, her owner’s equity would now be $40,000.
Keep in mind that Patty pays taxes on the $30,000 profit, regardless of how much she draws from the business.
Paying yourself in a partnership
Payment method: Owner’s draw
Capital contributions and business profits increase a partner's equity balance, which is reduced by partner (owner) draws and business losses.
Patty owns her own catering business and is also a partner at Alpine Wines, a wine and liquor distributor. Patty and Susie each own 50% of Alpine Wines, and their partnership agreement dictates that partnership profits are shared equally. Patty contributes $70,000 to the partnership when the business is formed, and Alpine Wines posts this journal entry:
The partnership generated $60,000 profit in year one, and $30,000 is reported to Patty on Schedule K-1. Patty includes the K-1 on her tax return and pays income taxes on the $30,000 share of partnership profits. Assume Patty decides to draw $15,000 at the end of the year. Here is her partner's equity balance after these transactions:
$70,000 contributions + $30,000 share of profits – $15,000 owner’s draw = $85,000 partner equity balance
Remember that a partner can’t be paid a salary, but a partner may be paid a guaranteed payment for services rendered to the partnership. Like a salary, a guaranteed payment is reported to the partner, who pays income tax on the payment. The dollar amount of any guaranteed payments lower the partnership’s profit.
Paying yourself from a Limited Liability Company (LLC)
Payment method: Owner’s draw
You must form an LLC according to your state’s laws, and the rules for LLCs differ slightly by state.
The IRS considers an LLC to be a sole proprietorship, partnership, or corporation. The rules explained above will apply to how Patty should pay herself as an LLC if she’s taxed as a sole proprietorship or partnership.
Paying yourself as an S Corp
Payment method: Salary and distributions
If Patty’s catering company were set up as an S Corp, she would figure out a reasonable compensation for her work and pay herself a salary. To avoid raising any red flags with the IRS, her salary should be similar to that of those in similar business positions. She’ll also need to withhold taxes from her paychecks.
However, to avoid withholding self-employment taxes on the whole amount, Patty could also take a portion of her compensation as a distribution. Distributions are from earnings that were previously taxed at her personal rate. Keep in mind that Patty also needs to have enough equity to take distributions.
For example, if Patty wishes to be paid $75,000 from her business, she might take $50,000 as a salary and distribute $25,000 as a distribution.
Paying yourself from a corporation
Payment method: Salary and dividends
Owners of a corporation are called shareholders. Let’s say that Patty’s catering company is a corporation, but she’s the only shareholder. She must pay herself a salary based on her reasonable compensation.
However, she can also receive a dividend, a distribution of her company’s profits, which would be taxed on her tax return.
Keep in mind that her business doesn’t have to pay a dividend. She could have the business retain some or all of the earnings and not pay dividends.
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Other considerations for paying yourself as a business owner
Figuring out how to pay yourself as a business owner can be complicated. Here are a few other things you’ll want to remember when deciding between a salary and a draw.
Social Security and Medicare taxes
Social Security and Medicare taxes (FICA taxes) are collected from salaries and draws.
Sole proprietors and partners in a partnership each pay self-employment taxes on the company's profits. The self-employment tax collects Social Security and Medicare contributions from these business owners. If, instead, a salary is paid, the owner receives a W-2 and pays Social Security and Medicare taxes through wage withholdings.
In contrast, S Corp shareholders do not pay self-employment taxes on distributions to owners. Still, each owner who works as an employee must be paid a reasonable salary before profits are paid. Remember, the IRS has guidelines that define a reasonable salary based on work experience and job responsibilities.
Risks of taking large draws
It’s possible to take a very large draw as the business owner. The business owner may pay taxes on his or her share of company earnings and then take a larger draw than the current year’s earning share. An owner can draw all contributions and earnings from prior years.
However, that isn’t without its risks. If the owner’s draw is too large, the business may not have sufficient capital going forward.
Say, for example, that Patty has accumulated a $120,000 owner-equity balance in Riverside Catering. Her equity balance includes her original $50,000 contribution and five years of accumulated earnings left in the business.
If Patty takes a $100,000 owner’s draw right now, her catering company may not have enough money to pay for employees’ salaries, food, and other business expenses.
Avoiding tax confusion
Depending on your business structure, you might be able to pay yourself a salary and take an additional payment as a draw based on the previous year's profit. Make sure you plan carefully to pay your tax liability on time to avoid penalties and be payroll compliant.
In addition, it is recommended that payroll records be kept for about six years to stay organized and payroll compliant.
Online payroll services will help you organize your payroll tax documents. Choosing the right provider, one that supplies expert support will be key in assisting with any tax confusion or compliance issues.
How to determine how much to pay yourself as a business owner
Maybe you’ve decided between a salary and a draw, but now you’re not sure how much you should be taking out of the business for yourself.
As we mentioned earlier, there isn’t one answer that applies to all business owners. Data from Payscale shows that the average business owner makes $69,647 annually. But, many business owners don’t take a salary in the first few years.
Here are a few things that you should consider as you’re crunching the numbers:
- 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 an owner’s draw.
- Business performance: Regardless of how you 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, suppose your business is a relatively new startup with a high growth stage. In that case, 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: The IRS may raise red flags if you take only a $10,000 salary from your company each year. Make sure you familiarize yourself with the IRS’ guidelines and ask around to determine a reasonable salary for your type of work.
- 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 those expenses, so you can make sure you’re taking home enough to cover them.
Those considerations will help you land on a suitable number to pay yourself, whether you take it as a salary or a draw.
Which method is right for you? Salary vs. draw
Your business entity will be the biggest determining factor in whether you take a salary or draw (or both). For example, if your business is a partnership, you can’t take a salary—you have to take an owner’s draw.
So, carefully review the above section on business classifications, as that will reveal a lot about the best way to pay yourself as a business owner.
Here are a few other things to consider:
- 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 must 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.
This decision regarding a salary or a draw impacts your business and your personal tax liability.
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Pay yourself the right way
You have a lot of love for your business, but you also know love doesn’t pay your bills. As a business owner, you need to pay yourself to cover your personal expenses and justify the time you spend working in your business.
But, of course, compensating yourself isn’t always straightforward. Use this article as your guide to determine whether you should take a salary or a draw and how much you should reasonably pay yourself.
That way, you can get what you deserve—without risking your business's financial health and compliance.
WRITTEN BY: KAT BOOGAARD
This article originally appeared on the QuickBooks Resource Center and was syndicated by MediaFeed.org.
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