Owner’s Draw vs. Salary: How to Pay Yourself as a Business Owner
When you decided to start your business, making money was most likely at the top of your priority list. But between unsteady profits, pouring money back into the business, and simply not knowing how much is “fair” to take, most business owners struggle with how to pay themselves a personal income.
Whether you’re a sole proprietor or a partner in a partnership, it’s important to strike a balance between getting reasonable compensation and not draining your business. Here’s what business owners need to know about paying themselves, as well as some handy tips on sorting out income tax.
Owner’s Draw vs. Salary
There are a variety of ways that business owners or shareholders can pay themselves, but the two most common ways are via owner’s draw and salary. Here are the fundamental differences between the two:
An owner’s draw is a one-time withdrawal of any amount from your business funds. However, owners can’t simply draw as much as they want; they can only draw as much as their owner’s equity allows.
Owner’s equity refers to your share of your business’ assets, like your initial investment and any profits your business has made. For example, if you invested $50,000 into your business entity and your share of the profit is $25,000, then your owner’s equity is at $75,000. If you draw $30,000, then your owner’s equity goes down to $45,000.
With owner’s draw, you have to pay income tax on all your profits for the year regardless of the amount you actually draw. The Internal Revenue Service (IRS) also requires that you pay your own self-employment taxes, Social Security and Medicare taxes, and estimated taxes as well.
Instead of taking a draw (the amount of which can vary per draw), you can choose to take a salary instead. A company owner’s salary works pretty much in the same way that a regular employee’s salary does—you decide on your wages, and you give yourself a paycheck every pay period.
If business owners pay themselves via a salary, both federal and state taxes are automatically taken out of their paychecks, so they don’t have to file their own Federal Insurance Contributions Act tax (FICA; Social Security/Medicare) or self-employment taxes. Owners can even give themselves a raise as their companies grow, and award themselves with quarterly or annual bonuses.
The biggest downside to taking a personal income is that you have to figure out how much is “reasonable compensation” for you and for the IRS. If the IRS considers your salary too high for the services you are rendering, it could raise a lot of red flags.
Which Is Best for You?
The type of payment method that you choose can be decided by a variety of factors, although none influence it more than your business structure/entity type (which we will go into more detail about below). You can also choose both methods and give yourself a salary while taking a draw from your equity. The drawback is that two completely different tax processes apply, so you’ll have to put in extra time and effort while preparing your personal tax return to avoid mistakes and missed deadlines.
Regardless of which one you choose—draw or salary—remember to always pay yourself from your business’ profit, not revenue! In addition, you must pay taxes on your income/profit to avoid getting flagged by the IRS.
How Do Small Business Owners Pay Themselves?
Before you are even faced with the decision of how to pay yourself, you need to decide what kind of structure you want for your business. Your business structure affects many aspects of your operations, including the best way to pay yourself as a business owner.
Below are the four main types of businesses and the recommended payment method (owner’s draw vs. salary) for each.
Most businesses opt to be recognized as a sole proprietorship because it’s the easiest and most affordable type of business to set up. In a proprietorship, you and you alone are the business owner, so you are legally recognized as one and the same entity. All profit goes to you as the sole proprietor, but you are also personally liable for any losses.
Sole proprietors usually take money from the business in the form of a draw, which then reduces your owner’s equity. You are taxed for the overall profit of your business, no matter how much you actually draw, and you have to file it on your income tax return for the IRS.
Under a partnership, you may have one or more people that you share business profits with. You receive money based on your share in the company and any prior partnership agreements. Like proprietorship, you and your business partners are liable for all losses incurred by the business.
Partners usually take money in the form of distributions, or their share of the profits. You can’t earn a salary under a partnership, but you can get guaranteed payments for any services you’ve rendered. Guaranteed payments are separate from your profit share, and you have to pay income taxes on them in addition to filing them on your personal tax return for the IRS.
Limited Liability Company
A limited liability company (LLC) is a business structure that separates owner(s) from the businesses they run. This means that, in the case of losses or lawsuits, individuals are not liable—the company, however, is.
Whether you’re running it on your own or with partners, business owners usually take a draw from the profits. Single-member LLCs are paid out and taxed by the IRS like sole proprietors, while multi-member LLCs are paid out and taxed like a partnership.
A corporation is a business entity that is usually comprised of multiple owners or shareholders. Like LLCs, individual owners are not responsible for any losses incurred by the company. There are two main kinds of corporations: S corps and C corps.
In an S corp, all shareholders have to pay taxes on their share of ownership. Shareholders get paid through distributions but they also take a salary (rather than a draw), especially since many shareholders are also typically employees.
In a C corp, owners receive non-taxable dividends if they are not actively working for the business. If you are an owner but also an employee, you can get both dividends and a salary (rather than a draw).
How Much Should You Pay Yourself?
As a business owner, you don’t want to take too much and drain your business. However, you also don’t want to take less than what you need and deserve.
Now that you know the different ways to pay yourself—draw vs. salary—the next step is to figure out how much you should take home. Below are some of the most important factors to consider.
We cannot stress this enough: How you structure your business significantly influences how you should pay yourself (draw or salary)! Take your time to consider if you want a proprietorship, partnership, LLC or corporation (a decision that impacts more than your payment method), and the rest will follow.
Technically, you can take as much money as you want, especially if you’re a sole proprietor or in a single-member LLC. But if you take a draw or salary that’s too large, you risk crippling your business.
Always take a look at your profits (and cash flow) before deciding on your paycheck. Make sure your share of the profit leaves enough left over for bills, income taxes, investments and other operating expenses. And again, take only from your profit, not your overall revenue.
Depending on what stage your business is in, the amount you take home could change. While this flexibility can make budgeting difficult, it also allows you to anticipate and adjust to what your business needs the most.
If your business is just starting or profits are relatively low, you’ll likely have to take a smaller paycheck until revenues stabilize. If your business is booming, then you can afford to give yourself a little bit more on top as a reward for good performance.
Don’t forget to take your own worth into account! As a business owner, you’re providing some incredible value to your company, so allow yourself to take what you deserve. Base your take-home draw or salary on your experience, previous salary in a similar position, hours worked, other contributions and the average for business owners in your industry.
Of course, you also have to take your business size and location into consideration . If you used to work at a major corporation in the city, that amount would likely be too large to justify for a small startup in a more rural location.
Being a small business owner is pretty much a full-time job, and everyone working a full-time job deserves a living wage. When you are deciding how much to pay yourself, make sure that the amount covers your personal expenses (food, rent, gas money, etc.) at the very least, with a little bit on top for savings and small luxuries.
- Be consistent with how you pay yourself, whether you choose owner’s draw or salary. This makes it easier to budget as an individual and as a business.
- When cash flow is tight, pay your employees and your suppliers before anything else. Putting yourself first, regardless of financial circumstances, can lower morale and divert crucial funds away from your operations.
- Don’t withdraw your entire profit amount. Keep some money in the company to allow for investments and growth—you can always raise your salary/draw amount down the line when business is more profitable.
Paying yourself can be tricky business, but it does get easier and more intuitive with time. Just keep in mind that your business is not an unlimited source of money, so don’t dip into your accounts without carefully considering the implications.