If you’re a sole proprietor, a member of a limited liability company (LLC), or a partner in a partnership, you need to think carefully about how you take money out 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 an owner’s draw to compensate themselves. You may decide to use one of these methods, or a combination of both.
What is an owner’s draw?
An owner’s draw (or simply a 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.
The business owner may withdraw profits generated by the business, or take out funds that the owner previously contributed to operate the company. An owner’s draw may also be a combination of profits and capital contributed.
A draw of company profits is taxable as income on the owner’s personal tax return, and owners must pay estimated tax payments and self-employment taxes on draws.
Should I pay myself a salary?
You may decide to pay yourself a salary, rather than take a draw. One advantage of taking a salary is that tax withholdings and benefit payments come out of your gross pay automatically.
How much should I pay myself as a business owner?
Business owners pay income taxes and self-employment taxes using either a salary or a draw. Your decision about compensation should be based on how much money your business needs to operate moving forward, and if you’re willing to do more personal tax planning by using the draw method.
Before you make the salary vs. draw decision, you need to form your business. There are many ways you can structure your company, and the best way to understand the differences is to consider C corporations (C Corps) vs. all other business structures:
- C Corporation: C Corps are subject to double taxation. The C Corp files a tax return and pays taxes on net income (profit). The owners can retain the after-tax earnings for use in the business, or pay shareholders a cash dividend. If a dividend is paid, the dividend income is added to other sources of income on the shareholder’s personal tax return.
- Pass-through entities: Most other business structures pass the company profits and losses directly to the owners. Sole proprietorships, partnerships, S Corporations (S Corps), and several other businesses are referred to as pass-through entities. Assume, for example, that your share of a partnership’s profit is $10,000. The partnership files a tax return, and issues you a Schedule K-1, which reports the $10,000 in income, and the $10,000 is added to your other income sources on your personal tax return. The partnership tax return documents the partners, the percentages of ownership, and the partnership’s profit- but no taxes are calculated on the partnership tax return.
There are some exceptions, but generally a business faces double taxation as a C Corp, or the company is a pass-through entity.
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. draw decision, you need to understand the concept of owner’s equity.
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. draw decision.
How to pay yourself as a sole proprietor
A sole proprietor’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 proprietor, 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:
|Owner's equity- Patty||$50,000|