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Business owner salary vs. owner's draw: How to pay yourself as a business owner
You love your business, but that doesn’t mean you can afford to work for free. Yet, figuring out how to pay 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 business owner salary or an owner’s draw.
Let’s look at a salary vs. draw, and how you can figure out which is the right choice for you and your business.
Owner’s draw or salary: How to pay yourself
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.
Step #1: Understand the difference between salary vs. draw
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):
Owner’s draw: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals, or when needed.
Business owner salary: The business owner determines a set wage or amount of money for themselves, and then cuts a paycheck for themselves every pay period.
Those are the nuts and bolts, but we’ll dig into even more details of salaries and draws in a later section.
Step #2: Understand how business classification impacts your decision
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:
Limited Liability Company
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 you can’t be both a partner and an employee.
(We have an entire section below that breaks down the different business classifications and the best way for each business owner to pay themselves.)
Step #3: Understand how owner’s equity factors into your decision
“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.
Step #4: Understand tax and compliance implications
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.
On QuickBooks’ small business blog, you can get help understanding your tax responsibilities as a small business owner.
Step #5: Determine how much to pay yourself
There’s a lot that goes into figuring out how to pay 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:
Step #6: Choose salary vs. draw to pay yourself
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.
Understanding the difference between an owner’s draw and a salary
We’ve covered the difference between an owner’s draw and a business owner 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 trader and owns a catering company called Riverside Catering.
What is an owner’s draw?
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 profits and capital she previously contributed.
Because Patty is a sole trader, 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.
Pros and cons of an owner’s draw
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.
What is a salary?
You probably already understand what a salary is: You get paid a set amount every pay period. It works really similarly when you’re the business owner. You determine your reasonable compensation and give yourself a paycheck every pay period.
For example, maybe instead of being a sole trader, Patty set up Riverside Catering as a Limited Company. She has decided to give herself an annual salary of £50,000 out of her catering business. From there, she could do the math to determine what her paycheck should be given her current pay schedule.
Pros and cons of a salary
Less admin work: Taxes are deducted from your paycheck 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, your salary still needs to fall within a reasonable compensation. Therefore, figuring out how much to pay yourself can be challenging.
Understanding owner’s equity
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. The Owner’s Equity formula 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.
Risks of taking large draws
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 earning 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.
Avoiding tax confusion
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 organised 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 organised. Choosing the right provider, one that supplies expert support, will be key in assisting with any tax confusion or compliance issues.
How to determine how much to pay yourself as a business owner
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. Some business owners don’t even take a salary in the first few years.
Here are a few things that you should consider as you’re crunching the numbers:
Business structure: Your business entity impacts a lot of your decisions. Many entities don’t allow you to take a salary, meaning you’ll need to take an owner’s draw.
Business performance: Regardless of which way you choose to pay yourself, it’s important to remember that your compensation as the business owner isn’t set in stone. You can make some changes as you consider your business’ performance. You should only pay yourself from your profits and not overall revenue. So, if your business is doing well, you might be able to increase your compensation.
Business growth: While performance is an important consideration, so is the current stage of your business. For example, if your business is a relatively new startup and in a stage of high growth, you’ll likely want to reinvest a lot of the profits back into the business, rather than pocketing them as compensation for yourself.
Personal expenses: Reasonable compensation will give you a starting point, but it doesn’t need to be your only answer. You have personal expenses—from your mortgage or rent to your savings account—that you need to fund. Get a good grasp on what those expenses are, so you can make sure you’re taking home enough to cover them.
Those considerations will help you land on a suitable number to pay yourself, whether you take it as a salary or a draw.
Which method is right for you? Salary vs. 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:
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 National Insurance and income taxes through each type of business entity. Your decision about a salary or owner’s draw 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.
Pay yourself the right way
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 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.
We hope this article has helped you decide how to pay yourself as a business owner. If you need more help in the process of starting your own business, our latest questionnaire can provide you with a personalised to do list to ensure you don’t miss out on any crucial steps.