One of the most important decisions you’ll make as a small business owner is determining the method and amount you’ll pay yourself. The law orders that you follow certain guidelines when it comes to compensation and income tax. However, you can exercise your own discretion in other matters, like setting your pay. You can consider two standard compensation methods: an owner’s draw or a salary.
Continue reading as we dive into the key differences between an owner’s draw and a salary to help you determine which is best for your business.
If you select an owner's draw as your method of compensation, you will transfer funds from your business income account to your personal account(s). You have some control over setting the frequency and draw amount; they aren't necessarily required to occur at regular intervals like a salary.
During profitable periods, you might be able to take a larger cut. However, that means you also might need to take a smaller cut during slower periods. There may also be periods where you need to make significant investments in other expenses.
The owner’s draw method may increase your taxable income and, therefore, increase your tax liability.
If you select a salary as your method of compensation, you get guaranteed payments where you set your wage amount and frequency, which may be helpful in monitoring cash flow. This method is reliable and predictable since you know exactly when and how much your payment will be per period.
With a salary, the taxes are deducted upfront with each paycheck, and bonuses during profitable periods can still be paid out as a salary.
The owner’s draw method offers greater flexibility than the salary method. Draws can be tied directly to your business's performance and taken as frequently or infrequently as necessary.
One disadvantage of the owner’s draw method is that taxes are not deducted until the end of the year. Therefore, you’ll need to ensure you have enough funds set aside to pay those taxes when they're due. Every time you take a draw, it reduces your business's equity, and therefore, fewer funds are available for future purchases.
The salary method is more predictable and better for tax purposes since you know exactly when your paycheck will hit your account and what the amount will be. Another advantage of the salary method is that it requires less time and effort from the business owner and bookkeeper. The salary method can be difficult to adjust during slow periods while also meeting the IRS criteria for reasonable compensation, which is a disadvantage.
The profit distribution method you use to pay yourself largely depends on your business entity’s legal and tax classifications. S corporations and C corporations typically pay salaries, while sole proprietors, LLC owners, and partnerships often utilize the owner’s draw.
Regardless of the method you use, you’ll need to decide how much to pay yourself. Average salaries for business owners range from $50,000 to $90,000, and it’s common for a business owner to not take a salary during the first few years of operation. During these early years of your business, it's common to invest your profits back into your business so it can continue to grow.
Sole proprietors are considered to be self-employed by the IRS from a tax standpoint. Because of this classification, they can only take an owner's draw instead of a salary.
If your business is classified as a partnership, you must take an owner's draw since you cannot simultaneously be a partner and an employee. You and your partners can define the compensation for owner's draw and whether it should differ per partner.
LLCs are given the flexibility to be taxed as a sole proprietorship, a partnership, or a corporation.
Like sole proprietors, single-member LLC owners are considered to be self-employed from a tax perspective. Because of this, if you operate a single-member LLC, you must select an owner's draw as your method of compensation.
If you own a C corporation, you would be considered a shareholder and would typically select the salary method as your form of reasonable compensation. You would also be entitled to dividends based on your business's profits, which may be taken optionally.
Like C corporations, S corporation owners typically select the salary method as their form of reasonable compensation. Some S corporation owners also take a distribution from the business, which helps reduce overall tax liability.
There are tax and compliance issues to be aware of for both forms of compensation. Whether you're taking an owner's draw or salary, you will be subject to FICA/self-employment taxes, which are a combination of Social Security and Medicare taxes.
If you run a sole proprietorship, partnership, or single-member LLC, you will pay these taxes based on your business's profits. If you take your reasonable compensation in the form of a salary for your S corporation, these taxes will be taken out via payroll withholdings.
After all of your business's liabilities are deducted, the remaining value invested into it is called owner's equity. Contributions of money, equipment, and other assets give your business equity.
If you take an owner's draw, it's important to understand your business equity, as your draw cannot exceed that total. Calculate your owner's equity by subtracting liabilities from your business assets.
You will also need to keep in mind “reasonable compensation” (also known as reasonable salary) guidelines as established by the IRS. The IRS defines reasonable compensation as “the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.”
These guidelines ensure someone doesn’t deliberately pay themselves well below market value for their work to misrepresent their company’s finances. Reasonable compensation does not apply to partnerships or sole proprietorships. It mainly pertains to C-Corps and S-Corps. Tax and legal professionals have criticized the concept of reasonable compensation because of its subjectivity and lack of easy-to-calculate compensation guidelines.
While selecting how to pay yourself is an important decision, it can also be difficult, especially if it's your first business. When small business owners are in doubt about financial compensation and other challenges, many trust 1-800Accountant, America’s leading virtual accounting firm for small businesses, for professional advice.
Whether it's small business tax advisory, business taxes, payroll, entity formation, or any of our professional accounting services, we have the affordable solutions you need to ensure your business remains compliant with whichever pay method you choose. Schedule a quick consultation–usually 30 minutes or less to learn more.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.
