Getting paid as a small business owner is the culmination of a job well done. Yet a surprising number of entrepreneurs don’t take anything out of their businesses. For example, approximately 49% of entrepreneurs don’t take any form of payment.
While it makes sense during the earliest days of your business, you still need to cover your personal expenses. When running a business, there are two ways to pay yourself: by taking a salary or via the owner’s draw method.
Let’s discuss these two methods of paying yourself.
There are two primary ways of paying yourself.
The owner’s draw option allows you to draw money from your business as and when you choose. You can take as much as you like or as little as you like, based on how the business is going. In most cases, this is the ideal choice for small business owners because of its flexibility.
A salary is just that. But, first, you become an employee with a regular salary. It will come directly from your payroll and be paid into your account monthly.
The best method depends on your business’s structure and how well it’s going.
The way you pay yourself is crucial because there are rules. For example, you can’t simply raid the cash register without incurring the wrath of the IRS.
You also need to be aware of the consequences of your liability. The insurance you will need for an LLC is designed to protect your business’s assets while your LLC protects your personal assets. None of these insurance policies will matter if you make a mistake when paying yourself.
For example, if you combine your personal and business finances, your creditors can target your personal assets. The same goes if an employee or customer decides to sue you.
Comprehensive insurance is essential, but it’s not a silver bullet. You also need to seek legal advice to ensure you are paying yourself correctly.
An owner’s draw applies to a sole proprietor, partner, or their respective LLCs. You simply draw money from the company for personal use.
Anything you take out of the business will be declared on your personal tax returns at the end of the tax year.
The main advantage of the draw method is that you can use it as much as you want. There are no restrictions on how many draws you can make. Moreover, you can draw as much or as little as you feel comfortable.
During the growth periods of their organizations, small business owners will use this method because they can attune it to the current state of their operations.
The downside is that any draws you make will affect your tax liability. As a result, you’ll need to consider personal tax planning, including self-employment taxes and quarterly tax payments.
An owner’s draw doesn’t alter their taxes but will increase their reportable personal income.
You also need to consider the impact on your business’s cash flow. Withdrawing too much could put an unnecessary amount of strain on your company.
The draw method has a significant influence on your taxes. You need to understand how they work for different types of businesses to plan accordingly.
Since you’re the business’s sole owner, you’re entitled to as much as the company’s money as you desire. You have nobody to answer to and can take payments as you see fit.
Technically, draws are cash distributions that have been allocated to you as the owner. However, you’re taxed based on the amount of profit earned from your business rather than the amount of cash you’ve taken out as a draw.
In other words, you need to look at the business as a whole to determine your liability.
Partnerships are treated much the same as sole proprietorships. Any profit is taxed as the owner’s personal income.
Each partner receives a proportion of the profits/losses based on the proportion of the business they own, as outlined in the partnership agreement. Once again, taxes are paid on each owner’s personal income tax returns.
The option to accept an owner’s draw as part of a corporation, or an LLC that has elected to be taxed as a corporation, is unavailable. The owners of a corporation can only take distributions or accept a regular salary.
If you choose to take a salary, you will receive a fixed amount every month. You’ll be treated as an employee of your company.
The salary method allows you to automatically have your state and federal income taxes deducted from your paycheck. Another advantage of this is that you can easily track your business capital because you have a consistent expense.
Showing a steady source of income is also handy on the personal side when applying for credit-related instruments like mortgages.
The problem with the salary method is determining what counts as reasonable compensation, as defined by the IRS. You must also concern yourself with double taxation and keeping your company’s cash flow in the black.
Your salary isn’t static or binding. It can be altered at any point. Business owners also have flexibility regarding when they pay themselves. You have three options to choose from:
- First, pay yourself a lump sum at the end of the year while taking a low salary.
- Offer quarterly bonuses correlating to company growth while taking a low salary.
- Adjust your annual salary based on your annual growth
It’s wise to talk to a financial advisor about the best way to compensate yourself in a way that keeps your taxes low and doesn’t hamper company growth.
Managing your compensation is far from straightforward. First, you must follow the rules, especially if running a corporation, and taxes to consider. Talk to a professional to learn more about the best way to pay yourself for all your hard work.
Do you take a regular salary from your business or an owner’s draw?