As the owner of a budding business, you have a lot of expenses to take care of. But have you considered how to pay yourself yet?
If you have, you’ve probably heard of paying yourself via owner’s draw vs. salary. So, what’s the difference? And how can you make sure you select the best option for yourself and your business?
It’s not simply black and white. Whether you take a draw or set yourself a salary, there are certain requirements you must follow and options to choose from. That’s why we’re breaking down:
The difference between owner’s draw vs. salary
Business entity types and requirements
Determining how much to pay yourself
Business equity
Taxation considerations
Keep reading to learn about your options.
Owner’s Draw vs. Salary: What’s the Difference?
The first step is to understand how owner’s draws and salaries work. Some business entity types require one or the other, so keep those rules in mind as you form your business and/or decide your payment method.
What is an Owner’s Draw?
When you, the business owner, take an owner’s draw, you take funds out of the business for personal use at either regular intervals or as needed. Draws don’t have tax deductions. Many small business owners pay themselves through this method.
Perks
Better flexibility
Don’t need to pay yourself a set amount
Drawbacks
Reduced business equity and available funds for future business spending
More administrative work to calculate and pay your self-employment taxes
What is a Salary?
A salary works the same as it would at any other job—except you get to set your own wages and pay periods! All you have to do is cut yourself the check every payday.
Perks
Less administrative work because your taxes are deducted from your paycheck automatically
More stable compensation
Easier to track your income and expenses
Drawbacks
You must be careful with cash flow in case your business has a tough month. While you can adjust your salary, it still needs to fall within the IRS definition of reasonable compensation (more on that later).
It can be challenging to determine how much to pay yourself.
Why Does Business Entity Type Matter?
Your business classification affects many areas, including how your company is taxed, your risk, and how you should pay yourself. You should select the type of business entity that will work best for you and be sure to understand the implications of that classification.
Note that you cannot pay yourself a salary in a sole proprietorship, partnership, or single-member LLC because you cannot be an owner and pay yourself as an employee.
Sole Proprietors
Recommended payment method: Owner’s draw
In a sole proprietorship, your equity balance is increased by capital contributions and profits and reduced by owner’s draws and business losses.
For example, we have Annie, a sole proprietor who owns a floral and plant design shop. She contributed $60,000 when she formed the business at the beginning of the year. Her journal entry for the capital contribution would look like this:
DebtCreditCash$60,000 Owner’s equity (Annie) $60,000
Annie’s owner equity account would have a beginning balance of $60,000. If her business generates $40,000 in profits during the year, her owner’s equity account increases to $100,000. The $40,000 in profit will be posted as income on Annie’s personal tax return. She will have to pay taxes on the profit regardless of how much she withdraws from the business.
Annie can take an owner’s draw whenever she’d like. She can also choose to take a portion or all of her $100,000 owner’s equity balance out of the business, which would reduce her equity balance. If she withdrew $60,000, her remaining owner’s equity would be $40,000.
Partnerships
Recommended payment method: Owner’s draw
If your business is a partnership, your equity balance works the same as a sole proprietorship. As a partner, you cannot receive a salary. You can, however, receive a guaranteed payment for services provided to the partnership. A guaranteed payment is reported to you, the partner, and you pay income tax on it. These guaranteed payments will decrease the partnership’s profit.
Let’s say our friend Annie is also a 50% owner of a coffee roaster and distributor, and Sarah owns the other 50%. Their partnership agreement states that profits are shared equally. If Annie contributes $50,000 when the business is formed, the corresponding journal entry will look like this:
DebtCreditCash$50,000 Owner’s Equity (Annie) $50,000
Here’s what would happen if the partnership brings in $100,000 in profit in one year:
$50,000 is reported to Annie on Schedule K-1.
Annie includes the K-1 on her personal tax return and pays income taxes on the $50,000 share of partnership profits.
Next, Annie decides to take an owner’s draw of $20,000 at the end of the year. Her partner equity balance after these transactions would be:
$50,000 contributions + $50,000 share of profits - $20,000 owner’s draw = $80,000
Limited Liability Companies (LLCs)
Recommended payment method: Owner’s draw
Laws around forming an LLC vary from state to state, so check with your state first to ensure you file your LLC properly.
An LLC can be taxed as a sole proprietorship, partnership, or corporation. Follow the rules above to pay yourself accordingly, depending on what type of LLC you have.
S Corporation
Recommended payment method: Salary and distributions
As the owner of an S corporation, you first need to figure out a reasonable compensation for your work to determine your salary. This should align with what people in similar roles at other companies earn to not raise red flags with the IRS. Of course, you’ll also have to withhold taxes from your paychecks.
In addition to your salary, you can opt to take a portion of your compensation as a distribution. Distributions come from earnings that were previously taxed at your personal rate. Before taking distributions, you should ensure you have enough equity to take distributions and assess which tax rate is more beneficial to you, standard payroll taxes vs. self-employment taxes.
For example, if Annie wants her total compensation from her floral and plant design business to be $70,000, she could pay herself a salary of $55,000 and distributions of $15,000.
C Corporation
Recommended payment method: Salary and dividends
An owner of a corporation is called a shareholder. Even if you are the only shareholder, you must pay yourself a salary based on your reasonable compensation.
Suppose Annie is the only shareholder of her floral and plant design shop. In that case, she could pay herself a dividend or a distribution of her company’s profits which would be taxed on her personal tax return, in addition to her salary. This is optional, as Annie could choose to keep some or all of the earnings in the business and not pay a dividend at all.
Salary vs. Draw: Additional Factors to Consider
How Much to Pay Yourself
After all that, you’re probably wondering how much you should pay yourself as a small business owner. Consider:
Business Structure: Understand the workings of your business type to spend wisely.
Business Performance: Be sure to pay yourself based on profit, not by overall revenue.
Business Growth: What stage is your business at? A startup might need to focus on reinvesting, while a more established company might be ready to use profits as compensation.
Reasonable Compensation: As discussed earlier, avoid alerting the IRS by following their guidelines and paying yourself a reasonable amount.
Personal Needs: You have bills, responsibilities, and your future to plan for—make sure your pay covers your personal expenses and savings.
Business Equity & Risks of Large Draws
You should always have a clear view of how your business is performing and how much business equity you have.
Owner’s draws are great for their flexibility based on how the business is doing. Still, huge draws could get your company in trouble if you’re left without enough capital to cover essential expenses.
For example, Annie now has $120,000 in owner equity in her floral and plant design business, including her initial owner’s contribution of $50,000 and profits from previous years. If Annie withdraws $100,000, she may not have enough funds to pay her employees, contractors, vendors, plant costs, and other expenses.
Taxation
We mentioned earlier that your business classification affects your tax liability. Make sure you know how you have to pay your taxes and when.
FICA Taxes
You will have to pay Social Security and Medicare taxes (collectively referred to as FICA taxes) whether you pay yourself via a salary or owner’s draw.
Self-employment Taxes: Sole proprietors and partners pay self-employment taxes, which account for their Social Security and Medicare contributions.
Salary: A business owner who takes a salary receives a W-2 and pays their FICA taxes through payroll withholdings.
S Corp Shareholders: S corp shareholders do not pay self-employment taxes on distributions to owners, but each owner who works as an employee must be paid a reasonable salary before profits are paid.
Tax Liability
Think of taxation as C corps vs. all other business structures.
C Corporations are subject to double taxation, meaning they file a tax return and pay taxes on their net income (profit).
Pass-through Entities: Typically, all other business structures pass company profits and losses directly to the owners.
Plan your compensation carefully and consult with your accountant to ensure you pay your taxes correctly and on time. If your business structure allows and you choose to pay yourself a salary and take additional payment as a draw, you have more tax considerations.
Do you still have questions about taking an owner’s draw vs. salary or need help determining how to pay yourself as a small business owner? Our experienced accountants will be happy to help you set up your compensation plan so that you remain compliant and maintain your company’s financial health. Contact us or call 603-505-2368 today to learn more.