As a small business owner, you’re undoubtedly juggling many responsibilities. From managing the day-to-day operations, keeping an eye on cash flow, and tracking business profits, to making crucial decisions about business growth.
However, one often overlooked yet critical decision is how you pay yourself. Do you take a salary or an owner’s draw? This question is not just about your income, but it also influences your tax liability, business expenses, and even business structure.
So, let’s delve into the intricacies of owner’s draw vs. salary to help you make an informed decision.
Key Takeaway
- The salary method involves paying yourself a regular wage, while the draw method involves taking money out of the business as needed.
- Your business structure is important in determining how you should pay yourself.
- Both salary and draw methods have pros and cons and tax implications.
- Accurate record-keeping is crucial, regardless of the way you choose.
Owner’s Draw vs. Salary: The Difference
Before we compare the salary method to the draw method, it’s essential to understand the basics of each.
Both methods are common ways small business owners pay themselves, but they function differently and have unique tax implications.
The salary method involves a business owner receiving a set amount of money on a regular pay period, similar to any other employee. This could be weekly, bi-weekly, or monthly.
On the other hand, the draw method involves the business owner taking money out of the business profits whenever they need or want to, also known as an owner’s draw.
Understanding Salary Method
The salary method, typically adopted by corporations like S Corp and C Corp, involves paying yourself a reasonable salary. This salary is a business expense, reducing the company’s taxable income, and it’s subjected to employment taxes, including Social Security and Medicare taxes.
Your salary is reported on a W-2 form and is subject to withholding for federal and sometimes state tax purposes. It provides a predictable income stream, benefitting personal budgeting and planning.
However, as the business owner, you’re also an employee in this method. So, you must comply with employment laws and regulations, including paying yourself at least the federal or state minimum wage. Your salary should also reflect the value of your work for the business.
Pros
One of the significant benefits of the salary method is its predictability. Regular paychecks help stabilize your finances and allow for easier budgeting.
Additionally, having a W-2 income can make qualifying for personal loans, mortgages, and other credit products easier. Lenders often favor a steady, predictable income when assessing your loan application.
Cons
On the downside, the salary method can be somewhat rigid. If your business is experiencing a cash flow crunch, you must still pay your salary. This could put additional pressure on your business funds.
Plus, salaried income is subject to self-employment taxes, which can be higher than the taxes on the owner’s draws. This increases your total tax bill, especially if your salary is substantial.
Can You Change Your Salary?
While your salary should be reasonably consistent, there are circumstances where you may want to change it. Perhaps your business is flourishing, and you want to reward yourself with a raise, or the company profits are down, and you need to tighten your belt.
Firstly, you can give yourself a raise. If your business is doing well and you’re making more money than expected, you might want to increase your salary. However, it’s important to remember that a higher wage means higher employment taxes.
Alternatively, you could reduce your salary. If your business faces financial challenges, you might need to decrease your salary to help improve cash flow. But remember, you must still meet the minimum wage requirements and pay yourself a reasonable salary for your work.
Understanding Draw Method
The draw method, typically used by sole proprietors, partners in a partnership, and members of a limited liability company (LLC), involves taking money directly from the business profits. It’s more flexible than the salary method, allowing you to draw money as needed.
An owner’s draw is not considered a business expense and does not reduce the business’s taxable income. Instead, you pay taxes on the business’s profits, not the draw. However, depending on your business entity type, these draws can be subjected to self-employment taxes.
Lastly, unlike the salary method, the draw method doesn’t guarantee a regular paycheck. After covering all business expenses and liabilities, you can only take an owner’s draw if there’s enough money in the business bank account.
Pros
One of the main advantages of the draw method is its flexibility. You can take money out of the business whenever needed, which can be especially useful in managing personal expenses.
Additionally, owner’s draws can sometimes result in lower taxes. Since draws are not classified as wages, they’re not subjected to payroll taxes. This can mean lower total tax liability, depending on your business structure and income.
Cons
While the draw method provides flexibility, it can also create instability. Since your income isn’t fixed, planning and budgeting for personal expenses can be more challenging. This unpredictability can be stressful, especially during lean business periods.
Moreover, regularly taking large draws can impact your business’s cash flow and hinder its growth. It’s important to balance meeting your income needs and ensuring the business has sufficient funds to operate and grow.
How Much Can You Draw?
The amount you can draw from your business depends on several factors, including the company profits, your personal financial needs, and the business’s cash flow. Remember, you can only draw from the owner’s equity account, not loans or other business income.
It’s essential to keep in mind that taking large draws can leave your business underfunded. Therefore, you should always ensure enough money is left in the business account to cover upcoming expenses, debt payments, and potential emergencies.
Lastly, consider the tax implications of your draws. Although owner’s draws aren’t taxed as income, they can still affect your overall tax liability. Be sure to consult with a tax professional to understand the impact of your draws on your personal tax return and self-employment tax.
Draw Method and Income Taxes
Regarding the draw method, there are specific tax implications to consider. You must pay income tax on your business profits, not the amount you draw.
However, the tax rules can vary depending on your business structure. How you handle your taxes will differ if you’re a sole proprietor, a partnership, or an LLC.
If you are a sole proprietor
As a sole proprietor, your business profits are considered income in your personal account. Therefore, you’ll need to pay personal taxes on your business profits, regardless of how much you draw.
This means you’re responsible for paying self-employment taxes covering Social Security and Medicare. These taxes are usually higher than employees’ payroll taxes, so planning for this additional tax liability is essential.
You can deduct legitimate company expenses as a sole proprietor to reduce your taxable income. However, the owner’s draws are not deductible as company expenses.
If you are in a partnership
Your share of the business profits is reported on your tax return, and you pay income tax. Like sole proprietorships, partnerships are not separate tax entities, so the partners pay taxes on their share of the business profits, not on their draws.
However, a partnership agreement can specify how profits (and losses) are split among partners. This agreement can also dictate how often and how much each partner can draw from the business.
One important point is that partners are not considered employees for tax purposes. This means you can’t receive a salary or wages from the business. Instead, you may receive what’s known as a “guaranteed payment,” which is essentially a predetermined amount that’s independent of the partnership’s profits or losses.
If you are in an LLC
If you’re a member of an LLC, how you’re taxed depends on how the LLC is structured for tax purposes. An LLC can be a disregarded entity (like a sole proprietorship) or a partnership, or it can be taxed as a corporation (S Corp or C Corp).
The tax treatment is similar to a sole proprietorship for single-member LLCs treated as disregarded entities. You pay taxes on the business profits, not on your draws.
For LLCs treated as partnerships, the tax treatment is similar to a partnership. The profits are distributed according to the LLC agreement, and each member pays taxes on their share.
If the LLC is treated as a corporation for tax purposes, then you, as a member, can be an employee and receive a salary. In this case, the tax treatment is similar to that of a corporation.
Which is Better? Method Recommendations
| Business Entity | Description | Recommended Payment Method | |
| Sole Proprietorship | Single owner, personally liable for business debts | Draw Method | |
| Partnership | Two or more partners share ownership | Draw Method | |
| LLC | Limited liability, flexible tax treatment | Depends on tax election | |
| S Corp | Corporations with pass-through taxation | Salary Method | |
| C Corp | Separate tax entity, potential for double taxation | Salary Method | |
Step-by-Step About How to Pay Yourself from Business Account
- Determine your payment method: Decide whether you’ll use the salary or draw method based on your business structure and financial needs.
- Set a reasonable compensation: If you choose the salary method, ensure your salary reflects the value of your work and meets minimum wage laws.
- Schedule your payments: Set up a regular pay period for a salary. For draws, decide how frequently you’ll withdraw money.
- Record the transaction: Make sure to record each payment in your accounting system correctly.
- Handle tax implications: Ensure you’re withholding enough for taxes if you’re on a salary. Remember to set aside money for income and self-employment taxes if you’re drawing.
How Can You Record For Each Method?
Regardless of your chosen method, recording your payments accurately is crucial. This helps keep your finances organized and makes tax time a lot easier.
Salary Method
When you pay yourself a salary, the payment should be recorded as a business expense. This is usually done through your payroll system, which should automatically generate a pay stub for each paycheck.
Next, make sure to keep track of all payroll taxes and withholdings. These will be reported on your W-2 form at the end of the year.
Finally, remember to report your salary as income on your tax return. This is crucial for complying with tax laws and avoiding potential tax liabilities or penalties.
Draw Method
Recording an owner’s draw is a bit different from recording a salary. Since it’s not a business expense, you won’t record it as such. Instead, you’ll decrease your owner’s equity account.
To do this, make an entry in your accounting system to debit your owner’s draw account and credit your business bank account. This reflects the decrease in your business’s assets and owner’s equity.
At the end of the year, your total draws will reduce the owner’s equity reported on your balance sheet. However, it’s important to note that draws do not affect your business’s taxable income.
Bonus Content: Reasonable Compensation
Determining a reasonable salary is crucial if you pay yourself through the salary method, especially for S Corp owners. The IRS requires you to pay yourself a “reasonable compensation” for your work.
This salary is comparable to those of other business owners in similar roles and industries. You can research comparable salaries using industry surveys, professional associations, or job posting sites.
You should also consider the size of your business, its profitability, and the amount of time and effort you put into your role. Remember that if your salary is too low, the IRS may reclassify some of your business profits as wages, which could increase your tax bill.
In Conclusion
Whether you pay yourself a salary or take an owner’s draw depends on many factors, including your business structure, profitability, cash flow, and personal financial needs. While the salary method provides more stability, the draw method offers more flexibility. However, both methods have tax implications that need to be carefully considered.
Remember, keeping accurate records of your payments, whether a salary or a draw, is essential. This will help ensure that your business finances stay organized and that you’re prepared for tax time.
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6 Responses
Interesting read. I’ve been using the draw method for a while now, and it’s great for flexibility, as mentioned. However, the article is right about the unpredictability of income, which can be a bit challenging for budgeting.
Great post! It’s so important for small business owners like myself to understand these concepts. Your explanations are clear and super helpful.
The blog effectively outlines the key differences between taking an owner’s draw and a salary, including tax considerations.
Useful content for small business owners and entrepreneurs looking to understand the best compensation strategies
Really insightful article! As a new small business owner, I’ve been grappling with the decision between a salary and an owner’s draw. Your breakdown of the tax implications and flexibility of each method is super helpful. Thanks for making this complex topic much easier to understand!
Interesting read. I’ve been using the draw method for a while now, and it’s great for flexibility, as mentioned. However, the article is right about the unpredictability of income, which can be a bit challenging for budgeting.