There’s a right and wrong way to pay yourself as a small business owner. Unfortunately, if you pay yourself the wrong way, you can even be saddled with IRS:
Instead of inadvertently sabotaging your accounting, it’s crucial to work with an accountant who will determine what reasonable compensation is for your business.
Draw vs. Salary to Pay Yourself
If you want to pay yourself, you’ll find that you can either use what is known as an “owner’s draw” or “salary.” The optimal choice for you and your business depends on multiple factors, but it’s still crucial to know about both payment methods first.
How Owner’s Draw Works
An owner’s draw is when the business transfers money directly to the business owner’s personal account. The money can be sent:
- As needed
When taking an owner’s draw, it’s often advantageous to the owner because they can take more or less money out of the business as profitability allows. However, for some entities, you’re not allowed to only take an owner’s draw. More on that later.
How Salary Works
An owner who wants to be paid the same amount regularly may want to consider salary and if it’s a good choice for their situation. The perks of taking salary are:
- Regular paychecks
- Paying taxes upfront
Owners may prefer the salary payment option because it allows them to maintain a predictable and recurring salary. Just because you’re taking a salary doesn’t exclude you from also taking an owner’s draw.
How Should You Pay Yourself?
The percentage of owners that take a salary and use the owner’s draw is almost even. One report found that 51% of owners took a salary. Due to the stability and reliability of a salary, this may seem like a good option.
In fact, if you own an S-Corp or C-Corp, you must pay yourself a salary.
Pay Yourself as an S-Corp
For an S-Corp, reasonable salaries are determined by what a traditional employee in the industry would earn given the same job description. You’ll want to use as many factors as possible to determine salary, including:
- Agreements pertaining to compensation
- Time and effort
Interestingly, one of the tips for small business owners is that as an S Corp, you can take a regular salary and owner’s draw, but you cannot take a draw in lieu of salary.
S-Corps are the most common incorporation type for small businesses, accounting for more than 40% of businesses. However, a C-Corp may be a better choice for your business type and operations.
Pay Yourself as a C-Corp
C-Corps work differently:
- C-Corp owners can have a salary similar to their peers
- Owner draws are possible, but the draw must be made as a dividend payment
Since a C-Corp will face double taxation, many owners opt to incorporate as an LLC or other entity. You’ll also need to know how to pay yourself if you’re not an S-Corp or C-Corp.
Pay Yourself as an LLC, Partnership, or Sole Proprietorship
In many cases, owners of all three business types will use the owner’s draw method of payment. The sole proprietorship and partnership businesses will find that their equity rises and falls with business profits.
LLC owners will have the option of paying themselves based on their tax status. For example, an LLC can be taxed as:
- Sole proprietorship
Your accountant can help you determine what the optimal tax status is for your LLC. By default, if the owner of an LLC is the sole owner, it will be seen as a single entity, with all profits being seen as personal income. However, if the business has two or more owners, it will be viewed as a partnership.
When to Start Paying Yourself?
As a business owner, you know how difficult the first few months or years of operation are. The business is just starting to gain traction, and it may even be challenging to fill your business pipeline to keep revenue coming into the business.
One strategy that many owners will follow to overcome this hump is to not take a salary.
If you’re not paying yourself yet and wondering when is the right time to start, it’s often when:
- Your business starts generating enough money
- Cash flow is strong
You’ll want to factor your salary into the business’ expenses at this time to ensure that you can financially afford to pay yourself. If you find that the business isn’t making enough money, it may be wise to hold off on paying yourself for as long as possible to allow the business to turn a profit and gain financial stability.
Avoid Issues with Mixing Bank Account Usage
A staggering 1-in-5 businesses fail in just the first year of operation, and one of the reasons is the lack of positive cash flow. One mistake from small businesses is that they often mix their business and personal expenses together.
If you mix accounts, this makes it difficult to:
- Do your taxes
- Prove which expenses are business or personal
Depending on the entity type that you choose, you may be legally required to have separate business and personal accounts. Maintaining your own business checking and savings account offers you many benefits:
- Remain financially solvent by not “dipping into funds” too much
- Maintain stronger cash flow
- Create stronger legal protection
In most cases, maintaining a separate business and personal bank account also offers more legal protection. If you argue that your business and you are two unique identities, it can be more difficult to prove, given that you are mixing the accounts. While it may seem like an inconvenience, avoid mixing your personal and business accounts.
It’s important that, as an owner, you pay yourself for the hard work you put into your business. However, it’s best to work with an accounting professional who can help you determine how to pay yourself when to pay yourself, and also the taxes involved with paying yourself.
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