Navigating the ins and outs of owning a business can be difficult, especially as a small business owner. With limited resources and funds at your disposal, determining how to pay yourself as a small business owner is an essential step toward long-term success. But where should you start? To help you understand your options, we’ve broken down the basics for you below.
Your choices: salary vs. owner’s draw
First, let’s look at the two main ways small business owners and entrepreneurs typically pay themselves. We’ll dive into each method by explaining how each system works and the respective pros and cons to consider.
Option 1: Salary method
We’ll start with salary. This is the method you are probably the most familiar with. Paying yourself a salary from your business is comparable to how you would usually pay an employee. Essentially, you cut yourself a paycheck on a regular schedule, and the taxes you owe are automatically withheld.
Here are the main points to consider if you choose to use the salary method:
Pros of paying yourself a salary:
- More stability:Having a recurring, stable salary expense is a huge benefit when it comes to budgeting your business costs and planning for your long-term goals.
- Automatic tax deduction:Paying your taxes via the salary method is a hands-off process, as your taxes are withheld upfront.
Cons of paying yourself a salary:
- Less flexibility:If you receive a salary as a small business owner, you must abide by the IRS’s “reasonable compensation” requirement; this means the salary you pay yourself needs to be comparable to that of an employee working in the same role in your industry.
Option 2: Owner’s draw method
Another option available to small business owners is a method called owner’s draw (also known simply as a draw). When you pay yourself via owner’s draw, you essentially write yourself a check to withdraw funds from your company’s profits on an as-needed basis. Keep in mind that this method requires you to take distributions from your business profits — not revenue. Make sure you don’t confuse the two.
The amount you can withdraw and deposit into your personal bank account is also dependent on your owner’s equity, which can be determined using the following formula:
Assets (cash, inventory, equipment, etc.) – liabilities (debts, bills, etc.) = equity
If you decide to take draws, you don’t have to pay taxes upfront every time. This means you need to be diligent in setting aside enough cash to cover your tax bills when you file every year.
Pros of paying yourself with owner’s draw:
- More flexibility: Using this method, you have more control over how much cash you want to draw at any given time. This allows you to pay yourself based on your business performance.
Cons of paying yourself with owner’s draw:
- No upfront tax deduction: Taxes are not automatically paid every time you draw, so you need to budget for your end-of-year tax bill. Because of this, you must keep detailed records to ensure every transaction is accounted for and documented.
How to pay yourself based on business type
Now that you know your owner’s salary options, it’s time to decide which method makes the most sense for you and your business needs. Your business structure is the biggest factor to look at here. Different payment methods work best for different business entities. We’ve listed the recommended methods for each type of business for you below.
- Salary method: S corporations (S corps) and C corporations (C corps)
- Owner’s draw method: Sole proprietorships, partnerships, limited liability companies (LLCs)
Corporations
As the owner of a corporation, you are typically required to pay yourself a salary. This is where the IRS’s “reasonable compensation” rule comes into play.
If your business is classified as a C corp, you are legally obligated to pay yourself a salary as a W-2 employee with the appropriate tax payments taken out. This is because C corps are owned by shareholders, which means its earnings are essentially “owned” by the company. If you own a C corp and want to pay yourself more money on top of your salary, it will need to be taken as a dividend payment.
S corps work in a similar fashion but with a few caveats. As the owner of an S corp, you still need to pay yourself a reasonable salary, but you can also take withdrawals on top of that. You just can’t take draws instead of paying yourself a regular salary.
It works a little differently for sole proprietorships, partnerships, and LLCs. Owners of these businesses are essentially self-employed and are not subject to the same rules as corporations.
Sole proprietors
When it comes to sole proprietorships, the draw method is your only option; you are not legally able to pay yourself a salary. During taxation, the IRS looks at what is left over after deducting business expenses on Form 1040 Schedule C of your tax return. This is considered your profit, which the IRS views as your personal income. You’ll owe personal income tax on your business profits, meaning it’s taxed at ordinary income tax rates.
Partnerships
Partnerships are very similar. The IRS does not consider partners to be employees, so you’re once again required to take draws to pay yourself and are taxed like a sole proprietor. However, there is another option available called guaranteed payments. These are payments made to yourself from a partnership. They are not dependent on the partnership’s income, so guaranteed payments can be useful for the early startup years of your business when your partnership may not yet be profitable. While guaranteed payments are not technically draws, they are taxed similarly and are not subject to income tax withholding.
LLCs
LLCs are somewhat more flexible. By default, the IRS treats single-member LLCs as if they were sole proprietors and taxes them the same way. However, if you are the only owner of your LLC, you have the option to choose how you want to be taxed (as either an S corp or a partnership) by filing Form 8832. Multi-member LLCs are classified as partnerships but can also elect to be taxed as an S corp. If you are unsure about the tax implications of each method, it never hurts to speak to a tax professional.
How much should you pay yourself as a business owner?
Once you’ve determined the best way to pay yourself, one question remains … how much should you pay yourself as a business owner?
The answer here will look different for everyone. To help you make the best decision for your unique situation, consider these additional questions:
- How is your business performing? Make sure you know your business inside and out! If you aren’t already, get familiar with your company’s financial reports and what kind of cash flow you have to work with. Remember, you need to turn enough of a profit to pay yourself a reasonable salary.
- What are your expectations for business growth? Are you just starting out as a new business owner? Is your business growing quickly? If your business is rapidly expanding, you need to make sure you have enough cash on hand to invest in potential growth opportunities as they arise. In this case, you might consider paying yourself enough to cover your basic expenses and put the rest of your profits toward growing your business.
- What personal expenses do you need to take into account? This will look different depending on where you live and how many dependents you have, but it’s important to have a good understanding of your family’s basic needs and how much you can reasonably expect to live on.
The bottom line
So what is the best way to pay yourself as a business owner? As we’ve learned, there is no one-size-fits-all when it comes to this decision. In the end, the decision to take a salary or owner’s draw hinges on your business structure, your flexibility, and your personal and professional goals.
Whichever method you choose, enjoy that first pay day … you earned it!
