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As a business owner, earning an income is a little more complicated when you own your own business. Depending on the type of business you have, you have a couple of ways to get paid. It’s vital you choose the right option to ensure you’re complying with the right tax laws.
- Business owners can choose from a salary or owner’s draw when deciding how to pay themselves. Sole proprietors may like an owner’s draw best while larger corporations are required to take a salary.
- Both choices have tax implications that the business owner needs to address.
- You must pay yourself a reasonable salary, equivalent to others in a similar position.
Step One: Determine Your Business Entity
The first step to paying yourself is to determine the type of business entity you have. The type of entity you work as can have an impact on the amount of taxes you will owe and the type of payment you can give yourself. Here are the most common types of business entities:
- Sole Proprietorship.
- Limited Liability Company (LLC).
A sole proprietorship is a business that is owned and operated by one person. This is the simplest and most common type of business entity and all income is taxed as personal income, meaning you’ll have to pay estimated quarterly taxes throughout the year.
A partnership involves two or more persons who share ownership and profits. All partners in the business report their share of the profits and losses on their personal tax returns.
An LLC is a hybrid between a corporation and a partnership. It offers the limited liability of a corporation (more on that in one second) and the flexibility of a partnership. Profits and losses are passed through to the owners’ personal tax returns and taxed at their individual rates.
A C Corporation is a type of business entity that is separately recognized from its owners for the purpose of taxation. It is called a C Corporation because it is taxed according to Subchapter C of the Internal Revenue Code. These corporations are subject to double taxation, meaning that the income earned by the corporation is taxed at the corporate level, and the shareholders or investors are also taxed on the profits they receive from the corporation in the form of dividends.
An S corporation is a special type of corporation that has the same legal protection as a C corporation but is taxed differently. Instead of the corporation paying income tax, the profits, losses, deductions, and credits are passed through to the shareholders and reported on their individual income tax returns. This means that the income of an S corporation is only taxed once (at the individual level) instead of twice (at the corporate and individual levels) like with a C corporation.
Step Two: Figure Out the Best Payment Method
When deciding how to pay yourself as a business owner, you’ll have two main options:
- Get paid via a salary.
- Do an owner’s draw.
Both of these methods are meant for different business types and have varying tax implications associated with them.
What is a Salary?
When a business owner pays themselves a set salary, it’s similar to any other employee getting a salary. Taxes are withheld from the paycheck and you’re paid on a regular schedule. This payment option is legally required for businesses that are corporations or LLCs that are taxed similarly to corporations.
Now, don’t think just because you’re the owner or one of the owners in the business that you get to arbitrarily decide how much you make. The IRS has a “reasonable” compensation rule that states you can only make what someone in a similar position would make.
What is an Owner’s Draw?
An owner’s draw is a method of taking money out of a business to pay yourself as a business owner. When an owner takes out a draw, the money is taken from the business’s capital account and deposited into the owner’s personal bank account. This money can then be used to fund personal expenses, such as a home mortgage, car payments, or other living expenses.
This type of payment is typically used by sole proprietors or individuals who own and operate their own businesses. The money taken out of the business as an owner’s draw is considered a form of income, and is subject to self-employment taxes, so business owners need to make sure they’re setting aside enough to cover these taxes. 30% of your income tends to be a good estimation.
By taking an owner’s draw, the business owner can still receive an income while keeping their business’s funds intact. It’s important to note that there are no tax deductions associated with an owner’s draw and all money taken out is considered personal income.
Pros and Cons of Taking a Salary
- Stability. Taking a salary ensures consistent cash flow which is beneficial when planning budgeting and forecasting.
- Potential tax benefits. Setting a standard salary can result in lower taxes, as certain deductions can be made.
- Avoidance of risk. A salary gives you a steady income, rather than relying on sporadic profits, reducing the risk in a business.
- Opportunity cost. Depending on the size of the salary you’re taking, this could reduce the amount of funds available to reinvest into your business.
- Can be difficult to know how much to take. Determining how much salary to pay yourself can be tricky since you must factor in the costs associated with taking a salary and pay yourself a fair wage for your work.
Pros and Cons of Owner’s Draws
- Allows the owner to have more control over their salary. Owner’s draws can be taken when the business makes a profit, so the amount of salary withdrawn can be tailored to how much effort the owner is putting into the business.
- More flexibility. An owner’s draw is simply taking money, as needed, from your business. Freelancers often do this, where most of what they make through their business becomes their salary. This provides more flexibility than a set salary.
- Tax implications. If an owner’s draw is taken, it will be taxed as income and the owner will be responsible for paying the self-employed tax on the amount taken out.
- Can lead to cash-flow problems. If the owner takes out too much in owner’s draws, it can leave the business short on cash, which can lead to problems paying bills and other expenses.
Choosing Between Salary and Owner’s Draw
When trying to decide whether to take a salary or an owner’s draw as a business owner, there are several factors you’ll want to consider, including:
- Business structure. Depending on the structure, taking a salary may be more beneficial for tax purposes. Certain business types are required to take a salary, while others get a choice.
- Business growth. The stage of growth of the business is another important factor to consider. If the business is just starting out and is likely to be in the red for some time, taking a salary may not be feasible. In this case, an owner’s draw may be the best option.
- Business performance. If the business is doing well and there is enough income to cover the salary of the business owner, taking a salary may be the best choice. However, if the business is struggling and needs additional finance, an owner’s draw may be the better option.
- Personal finances of the owner. The business owner’s personal finances should be taken into account when making the choice of how to get paid. A salary will offer more security, but if the owner needs more money to cover personal expenses, an owner’s draw may be the better option.
Step Three: Decide How Much to Pay Yourself
When asking yourself ‘how much should I pay myself as a business owner’, you need to first have a clear understanding of your business’s financial health. Before you set a salary for yourself, consider the following factors:
- Revenue. Examine your business’s current and projected revenue and determine how much you can afford to pay yourself without putting the business in a difficult financial situation.
- Expenditures. Carefully review your business’s current monthly and annual expenses and consider how large of a salary you can pay yourself without cutting into other necessary business expenses. If you don’t have many expenses, an owner’s draw might make more sense.
- Business goals. Set a salary or owner’s draw amount that helps you reach your business’s long-term objectives. For example, if you want to increase the number of employees you have, you’ll need the money to hire them.
- Availability of funds. Consider the funds you currently have available and the outside funding sources like startup loans. If you can use loans to help offset certain costs, you may be able to take a larger salary or draw.
- Market rate. Research the market rate for someone with your skills and experience and use this information to inform your salary amount.
- Consider your household needs. You’ll need to balance out your business needs and your personal financial needs when deciding how much to pay yourself. You need enough to cover your bills, but you also want some money saved to put back into the business.
Step Four: Establish a Payment Method
As a business owner, it is important to establish a payment method for yourself to ensure you are taking home a regular salary and benefits. There are a variety of options these days, many of which make it incredibly easy to pay yourself regularly.
- Writing a check. Although this method is a bit archaic, it is a simple and straightforward way to pay yourself. You can either write a check for the full amount of your salary or for a portion of it. If you choose to write a check for only a portion of your wages, you will need to decide when to issue the remaining portion throughout the month.
- Transferring funds electronically. This can be done through direct deposit or through a third-party payment processor. This is a convenient way to receive your salary as the funds are deposited directly into your bank account.
- Using a payroll service. A payroll service can help to automate the payment process and ensure accurate and timely payments for both you and your employees. Using a payroll service can also help with tax filing and other filing requirements. This is recommended more for larger businesses rather than sole proprietors.
No matter which method you choose to pay yourself, it’s essential to ensure that you are setting aside enough funds to pay your taxes and other expenses. Setting aside a portion of your pay each month to cover these expenses is a good way to ensure that you are adequately prepared.
Step Five: Select a Payroll Schedule
Payroll schedules are determined by the type of business you run and how often you plan to pay yourself. You can break down your payroll schedule into two different camps:
- For a sole proprietorship or single-owner LLC. These businesses can usually pay Themselves as often as they’d like, whether it’s weekly, bi-weekly, monthly, or quarterly.
- For a corporation. Corporations require a more structured payroll schedule, such as paying yourself monthly or quarterly.
When setting up your payroll schedule, you’ll want to also consider other factors such as:
- Your cash flow needs. If you’re trying to maximize your cash flow, you might consider taking smaller, more frequent payments.
- How much time you need to track your expenses and income. If you’re more concerned about the amount of time and effort tracking your income and expenses, a more spaced-out payment schedule might be more ideal.
No matter what you choose, make sure you keep accurate records of your payments and taxes, as well as a clear plan for how much you’re paying yourself over time. This will ensure that you stay on top of your finances and are able to make the best decisions for your business.
Step Six: Get Paid
Finally the fun part: actually getting paid. The process of getting paid as a business owner is a bit different than receiving a paycheck from an employer. If you’ve set your salary up to be paid out regularly, the funds should be transferred from your business account to your designated personal account.
If you’re not set up to receive regular payouts, you’ll need to manually move money each time you need it, which is an owner’s draw. As a business owner, you’re in control of your pay and when you receive it—which is both a blessing and a curse. Make sure you’re doing the following:
- Have a separate business and personal account. This can ensure you’re paying out just what you need for your personal expenses and still keeping some money on hand specifically for your business.
- Make a memo next to each transfer. If you pay yourself once a month or multiple times a month, make a memo next to each transfer. This memo helps you easily record what your “paycheck” is from your business.
- Utilize automatic transfers, if possible. If you get paid on a regular schedule from freelance clients or patrons to your business, you may be able to automatically transfer your payment from your business to your personal account. This can help you feel a little more like a regular employee who gets paid on a consistent schedule.
5 Tips for Setting Your Salary as a Business Owner
As a business owner, one of the most important decisions you make is determining the salary you will pay yourself. Here are five tips to help you set a salary that is both fair and sustainable:
- Analyze your business’ financials. Before setting a salary, review your business’s financials. Be sure to analyze your expenses, income, and cash flow to ensure that you’re able to pay yourself a fair wage while still remaining profitable.
- Research the market rate. Doing some research on the market rate for similar positions in your industry can help you determine a fair salary that is both competitive and reasonable for your skills and experience. Plus, the IRS requires this research to ensure you’re paying yourself a reasonable amount.
- Re-evaluate each year. Businesses are constantly growing, changing, and evolving. To ensure the sustainability of your salary, re-evaluate it each year to determine if it needs to be adjusted.
- Set aside funds for taxes. There’s a reason I’ve already stated this three times. Paying your taxes is an annoying but vital part of owning a business. As a business owner, you are responsible for paying taxes on your salary, and the IRS won’t be very happy if you opt not to.
- Consider non-monetary rewards. Don’t forget to consider non-monetary rewards when setting your salary. These can include benefits such as health insurance, vacation, and retirement plans. When you own your own business, you don’t automatically get these benefits as you would as a W2 employee, so you’ll want to make sure you’re including paying for these in your salary estimation.
Mistakes to Avoid While Paying Yourself
I’ll be honest, there are a lot of things that can go wrong when you pay yourself. Luckily, they can easily be avoided, but you just need to make sure you’re paying attention.
Paying Yourself Infrequently or Not At All
Paying yourself like an employee helps you see what’s technically income and what cash flow you have to put toward your business. So if you don’t pay yourself on a regular schedule or at all, growing your business is going to be difficult.
Mixing Personal and Business Finances
Take it from someone who knows, mixing business and personal finances causes a huge headache. For the first few years that I was self-employed, I just deposited all of my business’s money into a personal checking account. Come tax time, finding my business income versus other incoming and outgoing money was nearly impossible.
In short, have a separate business and personal bank account. This makes getting paid, and, in turn, paying yourself, a lot easier.
Not Considering the Tax Implications
Owning your own business comes with a ton of benefits. For starters, you’re your own boss, you get to make your schedule, and there are far fewer pointless meetings you have to attend. Despite these draws, a reason many folks avoid starting their own businesses is the tax consequences of doing so.
As a self-employed individual or business, you’re responsible for paying your own taxes and making sure employee taxes are taken out of their pay. It’s against the law to not pay these taxes, and doing so will result in huge fines and a giant past-due bill.
Where to Seek Advice and Mentoring
If you need a little guidance running your business, or you just want to improve your experience as a business owner, there are places dedicated to helping.
- Small Business Administration (SBA). The Small Business Administration provides guidance and mentoring to small business owners through its Small Business Development Centers (SBDCs). SBDCs provide free, confidential consulting and training to help entrepreneurs start and grow their businesses.
- SCORE. SCORE is a nonprofit organization that provides free, confidential mentoring, educational resources, and networking opportunities for small business owners. Through its network of experienced mentors, SCORE helps entrepreneurs develop a business plan, secure funding, and make other decisions to ensure their success.
- Local business resources. Depending on your location, there may be a local business resource center that provides mentoring, training, and other assistance to entrepreneurs. Check with your local Chamber of Commerce or Small Business Development Center to find out what resources are available in your area.
- Online forums. Joining an online forum for business owners is another great way to get advice and mentoring. On these forums, you can connect with others who have gone through the same struggles with their businesses and seek advice from their experiences.
Running a business can be difficult and demanding, and it can be hard to stay motivated when there are no rewards for your hard work. It’s important you know how to pay yourself as a small business owner. Whether you take a salary or an owner's draw, you need to know the implications of doing so. Plus, having a separate way to get paid helps you manage ongoing cash flow in and out of your business.