Cover the building rent: Check. Settle your vendor bills: Check. Pay your employees: Check. But have you paid yourself? Don’t forget that you are a part of your business expenses.
When running a business, owners tend to pour their heart and soul into making sure the company stays afloat. Unfortunately, passion doesn’t pay the bills, and you cannot afford to work for free. If you’re struggling with figuring out how to pay yourself, you’re not alone.
You’ve got options, so let’s take a minute to explore them.
Payroll Salary vs. Owner’s Draw
What’s the Difference?
When determining which one (or both) of these options are best, you need to take a step back and examine your business as a whole.
With an owner’s draw, the owner will take funds from the business for personal use. Pulling these funds can be on a regular schedule or just when needed, and don’t have tax deductions. Many small business owners do this rather than pay themselves a regular salary.
Owners should check to make sure their expenses qualify as deductible for the business according to the IRS. As for payroll salaries, this is familiar to most people. The owner decides a set wage for themself and collects that check every pay period.
Examine Both Sides
In business, there are pros and cons to every decision, and that’s especially true when determining how owners pay themselves. The advantage of a draw is flexibility based on how great the business is performing.
For example, Charlie owns a tuxedo shop that operates as an S Corporation. He decides to pay himself a fixed-base salary of $2,000 monthly but, rather than do it via payroll, he collects payment through a check that his business writes. When Charlie’s shop is in its busy season, he writes himself an additional discretionary amount based on his business’s cash flow.
With that being said, taxes won’t be deducted from his draws automatically. This means Charlie will need to tuck aside money towards federal and state income taxes as well as self-employment taxes.
Using an owner’s draw also reduces the business’s equity. This means a reduction of funds for future business spending.
If you’re thinking about using an owner’s draw, avoid taking out large draws. Draws too large can send your business in the red and leave you closed for business.
Look at Charlie’s tux shop again. If he has $120,000 in owner equity, including his original $50,000 contribution and earnings from past years. If Charlie takes out $100,000 worth of an owner’s draw, he runs the risk of not being able to pay employees’ salaries, fabric costs and other various expenses.
On the other hand, a payroll salary offers more stability and less planning at the expense of less flexibility. Let’s say our friend Charlie decides to pay himself on a payroll salary. Taxes will be taken out automatically and his compensation will be consistent.
This means tracking income and expenses will be simpler and any bonuses in the good months will be taxed. The disadvantage of this route is a smaller net take-home pay. Cash flow can also take a hit if the business has a down month, adding the pressure of ensuring your revenue is enough to cover your and your employees’ checks.
Consider Your Classification
It’s pretty cut and dry, right? Well, there are a lot of factors that can influence how you decide to pay yourself. Classification is the biggest one.
This isn’t a simple choice of do you want to pay yourself or just compensate yourself. Each business structure has its own rules when it comes to owner’s compensation.
For example, if Susan’s hair salon is a partnership, she’s not able to collect a salary paycheck because according to the IRS, you cannot be a partner and an employee.
Take a look at the main business entities and their best payment methods:
- C Corporations, for your payment method, consider a salary or dividend, also known as a draw.
- S Corporations, an appropriate payment might be a combination of salary and distribution.
- Sole Proprietorships, consider a draw payment method.
- Limited Liability Companies or Partnerships, you may have a combination of owner’s draw and guaranteed payments. Guaranteed payments are taxable draws that take precedence over regular draws.
Outside of being up-to-date on owner’s compensation rules, business owners should also be aware of the various tax implications. C Corps differ from other business entities because they’re subject to double taxation. Other classifications pass the company’s profits and losses to the owners. These are pass-through entities.
As earlier mentioned there are also self-employment taxes. These are paid by those who operate in sole proprietorships and partnerships as a collection of Social Security and Medicare contributions.
Small business owners paying themselves a salary collect a W-2 and pay those taxes through wage withholdings. On the opposite end, S Corps don’t pay self-employment tax on owner’s pay; however, owners working as an employee have to be paid a reasonable salary, per IRS guidelines, before profits are paid.
Naming Your Price
You’re not finished yet. Figuring out how to pay yourself is one thing. Determining what to pay yourself is another ballgame. There’s no one formula as businesses vary in industry, size and structure.
Some factors to consider:
- Your business structure. Know what your business entity is so you can make wise decisions.
- The business performance in the past year. Look at your profit as opposed to your revenue.
- Your business’s growth overall. Are you a startup that needs to focus on reinvesting as opposed to pocketing profits for compensation?
- What reasonable compensation looks like. The IRS is going to raise brows if you’re only taking a $20,000 salary, so check their guidelines to determine a reasonable salary.
- Your personal needs. Whether it’s your mortgage, rent or savings account — get an understanding of what those expenses are and make sure you’re able to cover them with your pay.
Looking over these components will give you a better idea of how much you can realistically afford to take for owner’s compensation. Be sure to consult your own accounting, tax or legal advisors to ensure you’re making the best decision for your business.