You love your business, but that doesn’t mean you can afford to work for free. Yet, figuring out how to pay for yourself as a business owner can be complicated.
You need to think carefully about how you take money out of your business entity. Typically, that’s done one of two ways: a salary or an owner’s draw.
Let’s look at salary vs. draw, and how you can figure out which is the right choice for you and your business.
Some business owners pay themselves a salary, while others compensate themselves with an owner’s draw. But how do you know which one (or both) is an option for your business? Follow these steps.
Before you can decide which method is best for you, you need to understand the basics. Here’s a high-level look at the difference between a salary and an owner’s draw (or simply, a draw):
Those are the nuts and bolts, but we’ll dig into even more details of salaries and draws in a later section.
There are a lot of factors that will influence your choice between a salary, draw, or another payment method (like dividends), but your business classification is the biggest one. The main types of business entities include:
Why does this matter? Because different business structures have different rules for the business owner’s compensation. For example, if your business is a partnership, you can’t earn a salary because Revenue Canada says you can’t be both a partner and an employee.
“Owner’s equity” is a term you’ll hear frequently when considering whether to take a salary or a draw from your business. Accountants define equity as the remaining value invested into a business after all liabilities have been deducted.
When you contribute cash, equipment, and assets to your business, you’re given equity—another term for ownership—in your business entity, which means you’re able to take money out of the business each year.
It’s important to understand your equity, because if you choose to take a draw, your total draw can’t exceed your total owner’s equity.
In addition to the different rules for how various business entities allow business owners to pay themselves, there are also various tax implications to consider.
Canada recognizes five broad categories of corporations. Each has advantages for certain types of businesses and tax rates, but none is perfect for everybody. Be sure to check in with a professional for advice before settling on one of these forms for your business.
There’s a lot that goes into figuring out how to pay for yourself. But here’s your next question: How much should you pay yourself?
There’s not one answer or formula that applies across the board. You’ll need to take the following factors into account:
Once you’ve considered all of the above factors, you’re ready to determine whether to pay yourself with a salary, draw, or a combination of both.
You’ll also have a better understanding of how much compensation you’re realistically able to take out of your business.
We’ve covered the difference between an owner’s draw and a salary at a high level, but now let’s take a look at the nitty gritty details of each, using an example: Patty, who is a sole proprietor and owns a catering company called Riverside Catering.
An owner’s draw refers to an owner taking funds out of the business for personal use. Many small business owners compensate themselves using a draw, rather than paying themselves a salary.
Patty could withdraw profits generated by her business or take out funds that she previously contributed to her company. She may also take out a combination of the profits and capital she previously contributed.
Because Patty is a sole proprietor, all of the income earned by her business will show up on her personal tax return and she’ll need to pay estimated tax payments and self-employment taxes on those earnings.
She doesn’t pay separate taxes on the owner’s draw because she’s simply taking out money that has been taxed in the past (which reduces equity) or money that will be taxed in the current year.
Greater flexibility: Rather than needing to pay herself a set amount, Patty’s compensation can fluctuate depending on how her business is performing.
Reduced funds: An owner’s draw reduces a business’s equity, which reduces the funds available for future business spending.
You probably already understand what a salary is: You get paid a set amount every pay period. It works really similarly when you’re a business owner. You determine your reasonable compensation and give yourself a paycheque every pay period.
For example, maybe instead of being a sole proprietor, Patty setup Riverside Catering as a corporation. She has decided to give herself a salary of $50,000 out of her catering business. From there, she could do the math to determine what her paycheque should be given her current pay schedule.
Less admin work: Taxes are deducted from your paycheque automatically. Additionally, your compensation as the business owner is a more stable expense, which makes it easier to track your income and expenses.
Cash flow: What happens if your business has a down month? While it’s possible to adjust your salary to give yourself some more wiggle room,, figuring out how much to pay yourself can be challenging.
Before you make the owner’s draw vs. salary decision, you need to form your business.
There are different types of corporations for tax purposes, and you have to select the one that accurately describes your corporation type at the end of the tax year. The corporation type determines whether or not the corporation is entitled to certain rates and deductions. Make sure you know which type applies to you:
Once you form a business, you’ll contribute cash, equipment, and other assets to 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. draw decision, you need to understand the concept of owner’s equity.
What’s equity? To put it simply, it’s an accumulation of money that has not been spent on the business or withdrawn over time for personal use. 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, are liability accounts, as are any long-term debts 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 may have an impact on the salary vs. draw decision.
Forgive us for sounding like a broken record, but the biggest thing you need to consider when figuring out how to pay yourself as a business owner is your business classification.
Why does this matter? Well, because many business entities don’t allow you to take a salary. Let’s take a look at each type of business entity and how this impacts the salary vs. draw decision.
Payment method: Owner’s draw
A sole proprietor’s equity balance is increased by capital contributions and business profits, and is reduced by the owner’s draws and business losses.
Let’s go back to Patty and her Riverside Catering business. In this example, Patty is a sole proprietor and she contributed $50,000 when the business was formed at the beginning of the year. Riverside Catering logs 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. Riverside Catering makes $30,000 in profit during the year. Since Patty is the only owner, her owner’s equity account increases by $30,000 to $80,000. The $30,000 profit is also posted as income on Patty’s personal income tax return.
Patty can choose to take an owner’s draw at any time. She could choose to take some or even all of her $80,000 owner’s equity balance out of the business, and the draw amount would reduce her equity balance. So, if she chose to draw $40,000, her owner’s equity would now be $40,000.
Keep in mind that Patty pays taxes on the $30,000 profit, regardless of how much of a draw she takes out of the business.
Payment method: Owner’s draw
A partners’ equity balance is increased by capital contributions and business profits, and reduced by partner (owner) draws and business losses.
Patty not only owns her catering business, but she’s 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 to the partnership when the business is formed, and Alpine Wines posts this journal entry:
The partnership generates $60,000 in profit in year one, and $30,000 of the profit is reported to Patty on T2125. Patty includes the T2125 on her personal tax return, and pays income taxes on the $30,000 share of partnership profits. Assume that Patty decides to take a draw for $15,000 at the end of the year. Here is her partner's equity balance after these transactions:
$70,000 contributions + $30,000 share of profits – $15,000 owner’s draw = $85,000 partner equity balance
Keep in mind that a partner can’t 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.
Payment method: Salary and dividends
Owners of a corporation are called shareholders. Let’s say that Patty’s catering company is a corporation, but she’s the only shareholder. She must pay herself a salary based on her reasonable compensation.
However, she can also receive a dividend, which is a distribution of her company’s profits. That dividend would be taxed on her personal tax return.
Keep in mind that her business doesn’t have to pay a dividend. She could choose to have the business retain some or all of the earnings and not pay a dividend at all.
Learn more about paying yourself a dividend or salary here.
Figuring out how to pay yourself as a business owner can be complicated. Here are a few other things you’ll want to keep in mind when deciding between a salary and a draw.
Payroll deductions are collected from both salaries and draws.
Sole proprietors and partners in a partnership each pay self-employment taxes on profits earned by the company. The self-employment tax collects CPP and EI contributions from these business owners. If, instead, a salary is paid, the owner receives a T4 and pays CPP and EI taxes through wage withholdings.
In contrast, Corporation shareholders do not pay self-employment taxes on distributions to owners, but each owner who works as an employee must be paid a reasonable salary before profits are paid.
It’s possible to take a very large draw as the business owner. The business owner may pay taxes on his or her share of company earnings and 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.
However, that isn’t without its risks. If the owner’s draw is too large, 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 owner’s draw right now, her catering company may not have enough money to pay for employees salaries, food costs, and other business expenses.
Depending on your business structure, you might be able to pay yourself a salary and take an additional payment as a draw, based on profit for the previous year. Make sure you plan carefully to pay your tax liability on time in order to avoid penalties and be payroll compliant.
In addition, to stay organized and payroll compliant, it is recommended to keep payroll records for about six years.
Online payroll services will help you keep your payroll tax documents organized. Choosing the right provider, one that supplies expert support, will be key in assisting with any tax confusion or compliance issues.
Maybe you’ve made the decision between a salary and a draw, but now you’re not sure how much you should be taking out of the business for yourself.
As we mentioned earlier, there isn’t one answer that applies to all business owners. Data from Payscale shows that the average business owner makes $70,220 per year. But, many business owners don’t take a salary in the first few years.
Here are a few things that you should consider as you’re crunching the numbers:
Those considerations will help you land on a suitable number to pay yourself, whether you take it as a salary or a draw.
Your business entity will be the biggest determining factor in whether you take a salary or draw (or both). For example, if your business is a partnership, you can’t take a salary—you have to take an owner’s draw.
So, make sure that you review the above section on business classifications carefully as that will reveal a lot about the best way to pay yourself as a business owner.
Here are a few other things to consider:
This decision regarding a salary or a draw impacts your business and your personal tax liability.
You have a lot of love for your business, but you also know that love doesn’t pay your bills. As the business owner, you need to pay yourself to cover your personal expenses and justify the time you spend working in your business.
But, of course, compensating for yourself isn’t always straightforward. Use this article as your guide to determine whether you should take a salary or a draw, as well as how much you should reasonably pay yourself.
That way, you can get what you deserve—without risking the financial health and compliance of your business.
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