Salary vs 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. And 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, an typically, that’s done one of two ways, with a salary or an owner’s draws

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 the best option for your business?

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.
• Salary: The business owner determines a set wage or amount of money for themselves, and then cuts a paycheque for themselves every pay period. 

Those are the nuts and bolts, but we’ll dig into even more details of salaries and draws later.

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: 

• Sole Proprietorship
• Proprietary limited company (Pty Ltd)
• Partnership
• Public Company
• Personal liability company

This matters because different business structures have different rules for the business owner’s compensation.

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. 

Step 5: Determine how much to pay yourself

There’s a lot that goes into figuring out how to pay yourself, and there’s not one answer or formula that applies across the board.

You’ll need to take the following factors into account:

• Business structure
• Business performance
• Business growth
• Reasonable compensation 
• Personal needs

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 salary at a high level, but now let’s take a look at the nitty gritty details of each.

Let's use the example of Patty, who is a sole proprietor 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 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.

Pros and cons of an owner’s draw

Pros: 

• Greater flexibility: Rather than needing to pay herself a set amount, Patty’s compensation can fluctuate depending on how her business is performing. 

Cons:

• Reduced funds: An owner’s draw reduces a business’s equity, which reduces the funds available for future business spending. 

What is a salary?

A salary works similarly when you’re a business owner, except it's you who determines what reasonable compensation is, then you pay yourself every pay period.

For example, maybe instead of being a sole proprietor, Patty setup Riverside Catering as a Private/Proprietary limited company (Pty Ltd) and has decided to give herself a salary of R50,000 out of her catering business. From there, she could do the math to determine what her pay cheque should be given her current pay schedule. 

Pros and cons of a salary

Pros:

• 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. 

Cons: 

• 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, you have to determine a reasonable wage that makes you happy and keeps your company operational. Plus, figuring out how much to pay yourself can be challenging. 

Business taxations to consider

Before you make the owner’s draw vs. salary decision, you need to form your business. 

There are many ways to structure your company: 

• Sole Proprietorship: Owned and operated by an individual, The sole proprietorship is not a legal entity, The business has no existence separate from the owner who is called the proprietor. The owner must include the income from such business in his/her own income tax return and is responsible for the payment of taxes thereon
• Proprietary limited company (Pty Ltd): The private company structure is by far the most common type of company registered in South Africa, due to its efficiency and simplicity. Property Limited, or its abbreviation (Pty) Ltd, refers to a company that trades for profit, and such a company can exist into perpetuity, irrespective of any shareholder change.
• Partnership: Each partner is taxed on their share of taxable profits in an individual capacity as a partnership is not registered separately for income tax purposes.
• Public Company: A public company is considered to be a juristic entity, that exists separately from its owners and shareholders, and can exist for perpetuity. A public is similar to a private company in that they are both considered to have a legal personality, and consequently, the shareholders of public companies have limited liability. Thus, where such a company liquidate, the shareholder’s loss is limited to the amounts that they originally vested, and they will not be held personally liable for debts incurred by the company.
• Personal liability company: Is a private company and must be set up by a Memorandum of Incorporation which must specifically state the company is a personal liability company and as such the name of the company ends in the word Incorporated. The directors of the company, as well as previous directors, are jointly and severally liable for any debts and liabilities of the company during their respective periods of office. The owners of a personal liability company are considered separate from the company.

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. 

Equity is an accumulation of money that has not been spent on the business or withdrawn over time for personal use.

Equity is calculated 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.

Paying yourself by business type or classification 

The biggest thing you need to consider when figuring out how to pay yourself as a business owner is your business classification, which is vital as 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. 

Paying yourself as a sole proprietor

Payment method: Owner’s draw

A sole proprietor’s equity balance is increased by capital contributions and business profits, and is reduced by 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 R50,000 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 R50,000. During the year, Riverside Catering generates R30,000 in profits. Since Patty is the only owner, her owner’s equity account increases by R30,000 to R80,000. The R30,000 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 R80,000 owner’s equity balance out of the business, and the draw amount would reduce her equity balance. So, if she chose to draw R40,000, her owner’s equity would now be R40,000. 

Keep in mind that Patty pays taxes on the R30,000 profit, regardless of how much of a draw she takes out of the business. 

Paying yourself in a partnership

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 R70,000 to the partnership when the business is formed, and Alpine Wines posts this journal entry:

The partnership generates R60,000 profit in year one, and R30,000 of the profit is reported to Patty on an IRP5. Patty includes the IRP5 on her personal tax return, and pays income taxes on the R30,000 share of partnership profits. Assume that Patty decides to take a draw of R15,000 at the end of the year.

Here is her partner equity balance after these transactions:

R70,000 contributions + R30,000 share of profits – R15,000 owner’s draw = R85,000 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 randamount of any guaranteed payments. 

Paying yourself from a Private/Proprietary Limited Company (Pty) Ltd / Public Company / Personal Liability Company  

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. 

Other considerations for paying yourself as a business owner

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:

Drawings

You can opt to simply draw lump sums from the business as and when you need them and without declaring an official salary.

Typically, these amounts are allocated to your loan account in the business and therefore they do not affect the company’s profit. This means that you are removing cash from the company but with no benefit to the company in terms of company income tax, but it also means that you have not officially 'earned' any income. Since these amounts are sitting in your loan account, they are due back to the company and are not officially yours.

What is very important to remember here is that you are increasing your loan account with this option. You will eventually have to return this money to the company as drawings are not officially yours.

Declare a salary

Like director’s dees, an official salary reduces your company profit and subsequently your company’s income tax. A salary also increases your personal income and therefore increases your personal income tax. It is important to note, that SARS treats allowances and benefits as though they are salaries in terms of tax. So if you think you can reduce your personal tax by paying yourself a cellphone allowance or a travel allowance, think again and make sure you chat to a tax expert before you set up your payslip.

However, an administrative benefit of this is that with an official salary, your company now becomes responsible for declaring your income and your tax to SARS. Your company will register with SARS as an employer and will deduct and pay over your PAYE every month instead of you having to pay over huge chunks of tax every six months. The company will also be required to issue you with an IRP5 and will send this info to SARS on your behalf.

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, as 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 R120,000 owner equity balance in Riverside Catering. Her equity balance includes her original R50,000 contribution and five years of accumulated earnings that were left in the business.

If Patty takes a R100,000 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.

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. 

There isn’t one answer that applies to all business owners, but 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’s 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. 
• Reasonable compensation: Only taking a R10,000 salary from your company each year is going to raise some red flags with SARS. Make sure you familiarize yourself with SARS’ guidelines and ask around to figure out what a reasonable salary for your type of work is.
• Personal expenses: That reasonable compensation will give you a starting point, but it doesn’t need to be your only answer. You have personal expenses, whether from your mortgage or rent to your savings account, that you'll 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, so you'll 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 a CPA to plan for your tax liability and any required estimated payments.
• Each method generates a tax bill: You’ll pay PAYE, 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.