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If you run a business and you’re not sure how to pay yourself, you’re not alone. Even with the help of guidelines from the IRS, determining what makes sense for you can seem complicated. Plus, more than 70% of business owners work more than 40 hours a week, so it’s not unusual for personal finances take a back seat to priorities like sales, marketing, production, administration, technology — and everything else you need to get done.
Fortunately, figuring out whether to pay yourself by owner’s draw or salary (while also staying in the good graces of the tax man) isn’t that difficult once you understand the basics.
There’s also some upside: Making the correct choice for you and your business will help you save on taxes, maximize cash flow, maintain tax compliance, and even avoid personal liability for your business’s debts.
So let’s dive in:
Salary and owners’ draw simplified
You probably already know there are two options for paying yourself. Here’s what they mean:
Salary: Paying yourself a salary means you pay yourself a fixed amount each pay period. When you choose to go with a salary, taxes will be withheld from your paychecks and your company will send your tax payments to the IRS on your behalf, just like any other employee. You will most likely be able to find a payroll provider who handles withholding, so that tax time is uneventful. In addition, taking a salary makes it easy to anticipate the company’s cash needs and it helps you pay your personal taxes in a timely way.
The IRS even requires owners of S-corps and C-corps who are involved with running the business to take salaries, which must include “reasonable” levels of compensation. We will discuss different entity types in more detail below.
Owner’s Draw: Also referred to as a “draw,” an owner’s draw is when you voluntarily choose to take money out of your business. After all, if your company makes $100,000 in profit, then that profit is all yours, right? Assuming there are no co-owners, you’re free to write yourself a check or even take money out of the cash register for your personal use. In fact, if you’re a sole proprietor, a draw is your only option for paying yourself.
It’s important to note that, draws are not limited to cash withdrawals, either. Going to the ATM or writing yourself a check are technically cash withdrawals, but you can take non-cash withdrawals too. For example, say your company gets a bulk discount when it buys computers. If the company pays for a computer at the discounted price and gives it to your family, that would also be a form of a draw or compensation.
Draws can be a fixed amount paid at regular times or can be taken as needed. As the business owner, you have the discretion on when to take draws. But, because no taxes are withheld or remitted to the IRS, you’ll need to keep tabs on where that cash flow is going and make quarterly payments or settle up at the end of the year.
If you’re a sole proprietor, it’s all coming from one big pot, but if you’re an LLC, intermingling your business and personal finances can result in losing your limited liability status.
Is it better to take a draw or salary?
The answer is “it depends” as both have pros and cons. An owner’s draw provides more flexibility — instead of paying yourself a fixed amount, your pay can be adjusted based on how well the business is doing or based on how much money you need.
However, when you take an owner’s draw, it chips away at the equity your company maintains. A salary, on the other hand, provides a stable, predictable income. Paying yourself a salary also has the benefit of reducing your business’s taxable net income.
How much should an owner’s draw be?
No one set rule exists about how much an owner’s draw should be and it’s at the owner’s discretion. Ideally, it should be a reasonable amount that allows the owner to cover their personal expenses while also leaving enough funds to cover a business’s operating expenses and future investments. That said, an owner may take up to 100% of the owner’s equity as a draw.
Salary vs. owner’s draw at a glance
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Salary, draws, and the IRS
As you can see above, your business entity type can play a major role in how you can pay yourself. Here’s a closer look at the implications of using different entity types.
Using draws is the only option for sole proprietors — you cannot legally pay yourself a W-2 salary. That’s because paying yourself a salary isn’t a deductible expense for tax purposes when you’re a sole proprietor. The IRS considers any payments you make to yourself a draw (and on the flipside, it considers any profits your business makes to be your personal income).
The good news is you won’t immediately have to pay tax on your draws. The bad news is these draws won’t reduce your taxable income like a salary would.
Here’s a quick example: Your customers buy $100,000 worth of products from you over the course of a year. Say your business expenses for the year are $60,000 and you’ve taken draws of $30,000.
At the end of the year, your taxable income would be $40,000 — the profits from the business, which your draws won’t reduce.
The IRS will tax this $40,000 (not the $30,000 you “drew”) as self-employment income so you’ll pay 15.3% tax for FICA. However, you will be able to take a deduction for half of the FICA tax you pay. And, then you will also pay income tax on that $40,000.
Much like sole proprietors, partners in a partnership must use the draw method to pay themselves. The IRS doesn’t consider partners employees of a partnership. Therefore, you are unable to pay yourself a salary. You will be taxed like a sole proprietor for your percentage of the partnership’s income.
Limited Liability Company (LLC)
If you are a single-member LLC (meaning, you are the only owner), the IRS will consider the LLC a “disregarded entity” and treat your business as if you were a sole proprietor. You’ll have the same taxation concerns as a sole proprietor.
However, the IRS allows you to choose how you want to be taxed by filing Form 8832. You can elect to be taxed as a partnership or S-corp. Note: the default taxation classification is sole proprietor unless you inform the IRS you would like to be taxed as an S-corporation with Form 8832.
For multi-member LLCs, the IRS default taxation classification is as a partnership. You’ll have the same taxation concerns as partnerships, as discussed above. You can file Form 8832 to elect taxation as an S-corp, only if all members agree.
S-corporation (S-corp or small corporation)
If your business is an S-corp, you must pay yourself a salary if you are actively involved in running and managing your business.
To keep you from avoiding employment taxes, the IRS requires S-corp owners to pay themselves a “reasonable salary” that is in line with their job duties, education, skills, and experience. There are services and websites available that will determine reasonable compensation for you. But you can also look at what other companies pay their officers to get an idea of what is reasonable.
You can also take draws as an owner of an S-corp. However, you can’t take draws in lieu of a reasonable salary.
The good news is that your salary and the 7.65% of FICA tax the S-corp pays on your salary is tax deductible and will reduce the company’s taxable income. Also, any business profits that aren’t paid out as salary or an owner’s draw will be taxed at the corporate tax rate (instead of the personal income tax rate for sole proprietors and partnerships), which is often lower than the owner’s personal income tax rate.
Much like an S-corp, C-corp business owners who are actively involved in the business must be paid reasonable compensation. The good news is that, like an S-corp, your salary and the company portion of FICA tax is tax deductible.
The major difference from an S-corp is that a C-corp usually should not allow owners to take draws. Since the C-corp is typically owned by shareholders, the earnings of the C-corp are “owned” by the company.
If a C-corp business owner wants to “draw” money, above his or her salary, it must be taken as a dividend payment. The bad news is that the dividend payment is not a tax-deductible expense. If you want to take a draw from a C-corp, the better option may be to take it in the form of a bonus. A bonus would be a tax-deductible business expense for your business, and on your personal taxes, you may qualify for a flat bonus tax rate, which could be lower than your personal income tax rate.
Also, be careful to not pay yourself unreasonably high compensation. The IRS has taken the position that excessive compensation is a “disguised” distribution of company profits. In turn, these “disguised” distributions are really dividends in the eyes of the IRS and lose their tax-deductibility.
Simple and seamless
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— Alyssa Johnson, Electric Regatta LLC
How to determine reasonable compensation
After you settle on the best approach to paying yourself, the lingering question to answer is what exactly constitutes “reasonable compensation” in the IRS’ eyes? After all, the guidance from the government tax authority is that the pay should be reasonable.
But that doesn’t really tell you how much you should pay yourself as a business owner. The good news is that the IRS has issued some clarification on this front over the years. The agency defines “reasonable” on its website as follows:
“Reasonable compensation is 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.”
Yet another IRS website page dedicated to the topic suggests that public libraries may have reference sources that outline the average compensation paid for various types of services. You can also easily conduct research online for such salary or pay guidance, using platforms such as Glassdoor, Payscale, and Salary.com. In addition, the U.S. Bureau of Labor and Statistics website maintains a database of salaries by occupation and industry that can be a helpful guide.
Some additional considerations to keep in mind when establishing a reasonable pay include your level of education, your total years of work experience, and the cost of living in your region. You might also base your salary on your personal expenses or pay yourself a percentage of your profits.
Be careful with loans!
Steer clear of classifying any money you draw as a loan. Loans to owners must have terms like those required in traditional lending arrangements. That means there must be a signed promissory note, with stated reasonable interest rate, and a repayment schedule. There must also be consequences for non-payment. Otherwise, you risk the IRS reclassifying these “loans” to dividends or salary.
Plan ahead for taxes
The U.S. income tax system is a pay-as-you-go system and you are expected to pay taxes as you earn your revenue. If you’re using the draw method, you’ll need to set aside enough money to pay your tax bill. This may require you to make estimated quarterly payments to the IRS: If you owe more than $1,000 on April 15, you’ll be penalized.
Deciding how to pay yourself as a small business owner is an important consideration, one that can have tax ramifications for your and your business. As a sole proprietor, single member LLC, or even as a partner in a partnership, you’ll be required to take an owner’s draw, for which taxes are not initially withheld.
For other types of small businesses owners, such as S-corps or C-corps, the options also include taking a standard, recurring salary each pay period, for which the taxes will be withheld and sent to the IRS.
Taking the time to understand these choices and the benefits and drawbacks associated with each will save you a great deal of headache in the long run. If you still have lingering questions about how to pay yourself, talking to a tax pro is always a good next step. No two businesses are the same — nor are the needs of business owners — so someone who understands your situation better will be able to help you make the right decision between paying yourself a salary or taking an owner’s draw.
This article is for informational purposes only and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors for formal consultation.