As a small business owner, you need to make decisions all the time. One of the most important decisions you’ll make is how and how much you’ll pay yourself. The law orders that you follow certain guidelines when it comes to compensation. However, you can exercise your own discretion in other matters, like setting your pay. There are two standard compensation methods that business owners can consider: an owner’s draw vs. salary.
What Is a Salary?
With a salary, you set your wage amount and frequency. This method is reliable and predictable since you know exactly when and how much your payment will be per period.
Remember that with a salary, the taxes are deducted upfront with each paycheck. Pay bonuses during profitable periods can still be paid out as a salary.
What Is an Owner’s Draw?
For an owner’s draw, you transfer funds from the business to your personal account(s). You have some control in setting the frequency and amount for these transfers; they don’t necessarily need to occur at regular intervals like with 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.
You may need to withdraw some of the capital you’ve invested in your business if you’re not drawing from the profits. However, your draw cannot exceed the amount of equity you’ve put into the business. You’d pay taxes on these funds at the end of the year. It’s important to remember that the owner’s draw method may increase your taxable income and therefore increase your tax liability.
Pros and Cons of Owner’s Draw vs. Salary
The owner’s draw method offers a greater level of flexibility than the salary method; draws can tie directly to the company’s performance. You can take draws as frequently or infrequently as you see necessary.
One con to the owner’s draw method is that taxes are not deducted until the end of the year. Meaning, you’ll need to ensure you have enough funds set aside to pay those taxes at a later date. It’s also worth remembering that every time an owner takes a draw, it reduces the company’s equity, and therefore fewer funds are available for future purchases.
The salary method is more predictable 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. One con of the salary method is that it can be difficult to adjust during slow periods while also meeting the IRS criteria for reasonable compensation.
How Do Different Entity Owners Pay Themselves?
The method you use to pay yourself largely depends on your business’s legal and tax classifications. S-Corps and C-Corps typically pay salaries, while sole proprietors, LLCs, and partnerships often utilize the owner’s draw.
It’s a preferred practice, and in some cases legally mandated, that you maintain separate business and personal accounts for your finances. It’s also important to remember the difference in filing taxes on behalf of your business and your own individual tax return.
How to Know How Much to Pay Yourself
Regardless of the method you use, you’ll need to decide on 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 company’s first few years. During these early years of your business, it may be more important to invest your profits back into the company, so it can continue to grow, as opposed to going straight to cutting yourself a check.
Once you do begin to take a salary, you’ll need to consider several factors to determine how much to actually pay yourself. Your business’s performance is one of the biggest factors. If you put in extra hours, provide top-notch service, hire and retain the right people, and do anything that contributes positively to your business’s bottom line, you should adequately compensate yourself for your efforts.
You should also consider slower periods or periods where you will have additional or unforeseen expenses. In these cases, you likely will need to consider a pay cut. Your salary must cover your personal expenses (mortgage or rent, car loan, etc.), and you should know how much you need to make to cover those costs.
What Is Reasonable Compensation?
You will also need to keep in mind “reasonable compensation” 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.
Questions about owner’s draw vs. salary or reasonable compensation? Consult with a tax and payroll professional to ensure you’re following proper protocols applicable to your company when it comes to paying yourself as a small business owner.
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.