September 9, 2022
Reading time: 5 mins
Working for free is unsustainable, no matter who you are. Like everyone else, business owners need money to put food on the table. That raises an important question: how should you pay yourself?
Typically, small business owners pay themselves through a salary or an owner’s draw. This article provides a basic overview of both methods to help you decide which is best for you and your business. We’ll start with each method's main advantages and disadvantages and finish by discussing the importance of business structure.
An owner’s draw is when the business owner takes money out of the business for personal use. The draw comes from owner’s equity - all the funds you have invested in your business plus your share of the business’s profits. These funds are sitting in your business bank account. As the account owner, you can write a check to yourself whenever you want, and there is no limit to how much you take out.
An owner’s draw is a fund transfer rather than a business payroll expense, which means it is subject to federal, local, and self-employment taxes but not payroll taxes.
- Greater flexibility: rather than pay yourself a fixed amount of money at regular intervals, your compensation can vary depending on how your business is performing. (To monitor your performance and plan your draws accordingly, you can use accounting software)
- Lowers growth potential: an owner’s draw reduces business equity, which lowers the funds you have available for future business spending and investment
A salary is a fixed amount of money that a business owner pays themselves on a regular basis (usually weekly or monthly). A salary is considered a business payroll expense, which means it is subject to payroll taxes.
- Less admin work: state and federal personal income taxes are deducted from your paycheck automatically. Also, since the payments are on a regular schedule, it’s easier to track expenses and manage cash flow
- Less flexibility: it’s harder to make adjustments based on business fluctuations. Plus, any salary adjustments must meet the current guidelines on “reasonable compensation,” or else it will raise flags with the IRS
The legal structure of your business is the starting point for the entire payroll process. While other factors also affect your choice between taking a salary or an owner’s draw (e.g. business performance, personal needs, etc), your business’s legal structure is the biggest one.
Why? Because there are different rules on the type of compensation a business owner can receive based on company structure. Keep the following points in mind when thinking about how to pay yourself.
Sole Proprietorships and Partnerships
If your organization is a partnership or a sole proprietorship, you must pay yourself through an owner’s draw - you can’t pay yourself a salary because the IRS considers you to be self-employed.
What matters here is that you are paying yourself through the business’s profits. As a result, you have to estimate your tax payments (based on those profits) rather than having them withheld, which is how you typically pay taxes when taking a salary.
LLCs can choose to be taxed as sole proprietorships (single member LLCs), partnerships (multi member LLCs), or an S-Corp. If you choose to be taxed as a sole prop or partnership, you must pay yourself through an owner’s draw. Alternatively, if you choose to be taxed like an S-corp, you’ll have the option to pay yourself a salary.
C-Corps and S-Corps
C-Corp and S-Corp business owners who are actively running the business must pay themselves a salary. S-Corp business owners can also take draws, but not in place of a reasonable salary.
On the other hand, C-Corp business owners don’t take draws since the company owns the business's profits. If a C-Corp business owner wants to get paid over and above their normal salary, it must be taken as a dividend payment.
Still unsure about how to pay yourself?
If you need more information before deciding how to pay yourself, reach out to email@example.com and schedule a free consultation with a Hansa expert. Ask as many questions as you want and get our personal recommendation on how to pay yourself, all in one session!