If you’re a sole trader or a partner in a partnership, you need to think carefully about how you take money out of your business entity.
Use these tips to determine how you should pay yourself as a business owner.
How to pay yourself from your business
Some business owners pay themselves a salary, while others take a share of profits to compensate themselves. You may decide to use one of these methods, or a combination of both.
What is taking profits?
Taking profits refers to an owner taking funds out of the business for personal use. Many small business owners compensate themselves this way by paying themselves a dividend rather than paying themselves a salary.
The business owner may withdraw profits generated by the business, or take out funds that the owner previously contributed to operate the company. A drawdown of company profits is taxable as income on the owner’s personal tax return.
Should I pay myself a salary?
You may decide to pay yourself a salary, rather than pay yourself a dividend. One advantage of taking a salary is tax comes out of your gross pay.
How much should I pay myself as a business owner?
Business owners pay income taxes. Your decision about compensation should be based on how much money your business needs to operate.
What is owner’s equity?
Once your form a business, you’ll contribute cash, equipment, or other assets into the business. When you contribute assets, you are given equity (ownership) in the entity, and you may also take money out of the business each year. To make the salary vs. dividend decision, you need to understand the concept of owner’s equity.
Accountants define equity is defined as the true value of a business, and equity is based on the balance sheet formula:
Assets – liabilities = equity
Assets are resources used in the business, such as cash, equipment and inventory. Liabilities, on the other hand, are obligations owed by the business. Accounts payable, representing bills you must pay every month, is a liability account, along with any long-term debt owed by the business.
If a company sells all of its assets for cash, and then uses the cash to pay all liabilities, any cash remaining is the firm’s equity.
Each owner can calculate his or her equity balance, and the owner’s equity balance has an impact on the salary vs. dividend decision.
How to pay yourself as a sole trader
A sole trader’s equity balance is increased by capital contributions and business profits, and is reduced by owner draws and business losses.
Assume, for example, that Patty owns Riverside Catering as a sole trader, and that she contributed $50,000 when the business was formed at the beginning of the year. Riverside Catering posts this entry to record Patty’s capital contribution:
A normal balance for an equity account is a credit balance, so Patty’s owner equity account has a beginning balance of $50,000.During the year, Riverside Catering generates $30,000 in profits. Since Patty is the only owner, her owner’s equity account increases by $30,000 to $80,000. Also, the $30,000 profit is posted as income on Patty’s personal tax return.
At the end of the year, Patty can choose to take a dividend, which refers to taking money out of the business. Patty could take some or all of her $80,000 owner’s equity balance out of the business, and the dividend would reduce her equity balance.
Patty pays taxes on the $30,000 profit, regardless of how much of a dividend she takes out of the business.
How to pay yourself in a partnership
A partner’s equity balance is increased by capital contributions and business profits, and reduced by partner (owner) draws and business losses.
Patty is also a partner in Alpine Wines, a wine and liquor distributor. Patty and Susie each own 50% of Alpine Wines, and their partnership agreement dictates that partnership profits are shared equally. Patty contributes $70,000 into the partnership when the business is formed, and Alpine Wines posts this journal entry:
The partnership generates a $60,000 profit in year one, and $30,000 of the profit is reported to Patty. Patty includes the amount on her personal tax return, and pays income taxes on the $30,000 share of partnership profits. Assume Patty decides to take a dividend of $15,000 at the end of the year. Here is her partner equity balance after these transactions:
$70,000 contributions + $30,000 share of profits – $15,000 owner draws = $85,000 partner equity balance
A partner cannot be paid a salary, but a partner may be paid a guaranteed payment for services rendered to the partnership. Like a salary, a guaranteed payment is reported to the partner, and the partner pays income tax on the payment. The partnership’s profit is lowered by the dollar amount of any guaranteed payments.
Risks of taking large dividends
A business owner may pay taxes on his or her share of company earnings, then take a draw that is larger than the current year’s earnings share. In fact, an owner can take a draw of all contributions and earnings from prior years. If the owner draw is too large, however, the business may not have sufficient capital to operate going forward.
Say, for example, that Patty has accumulated a $120,000 owner equity balance in Riverside Catering. Her equity balance includes her original $50,000 contribution, and five years of accumulated earnings that were left in the business. If Patty takes a $100,000 dividend, the catering company may not have sufficient capital to pay for salaries and food costs.
Avoiding tax confusion
You may pay yourself a salary, and take an additional payment as a draw, based on profit for the year. Paying a salary and taking an owner’s draw requires the business owner to pay taxes using two different methods, and you need to plan carefully to pay your tax liability on time in order to avoid penalties and be payroll compliant. In addition, to stay organised and payroll compliant, it is recommended to keep payroll records for about six years. Online payroll services do have the ability to keep your payroll tax documents organised. Choosing the right provider that supplies expert support will be key in assisting with any tax confusion or compliance issues.
The right method for you: salary or draw
Most businesses are set up as a sole trader, company or a partnership, which means that you may have the opportunity to take a draw or a salary (or both). Base your decision on these factors:
- Business funding: You need to leave enough capital in the business to operate, so consider that before you take a draw.
- Tax liability: A business owner needs to be very clear about the tax liability incurred, whether the distribution is a salary or a draw. Work with an accountant to plan for your tax liability, and any required estimated payments.
- Each method generates a tax bill: You’ll pay Medicare and income taxes through each type of business entity. Your decision about a salary or owner’s dividend should be based on the capital your business needs, and your ability to perform accurate tax planning.
This decision regarding a salary or a draw impacts your business and your personal tax liability. Before making a decision on the best way to approach how to pay yourself, it is recommended that you seek professional advice form your Tax Agent.