How To Pay Yourself as a Business Owner: Salary vs. Owner’s Draw

By Vladana Donevski

June 19, 2023

If you’re running a business, knowing how to pay yourself as a business owner is essential. This can be a tricky process, as there are several factors to consider, such as tax implications and the best interests of your business.

This article will discuss the different ways small business owners can pay themselves and help you decide which method is suitable for you. We will also take a quick look at each payment method’s tax implications and give you tips on avoiding mistakes while doing so.

Paying Yourself as a Business Owner: The Two Options

One of the first things you need to decide when figuring out how to get paid for your work as a business owner is whether you want to take a salary or an owner’s draw.

Paying Yourself a Salary

A salary is a regular paycheck taxed like any other employee’s income.

For the self-employed, salary can mean different things. While some may take home whatever is left after they pay taxes and handle all the business expenses, others may set aside a specific monthly amount that goes towards their personal expenses.

Paying yourself a salary when self-employed should not pose a problem, provided that you maintain accurate financial records. One method of calculating compensation is to calculate your net income first, which is your total revenue minus any business expenses. The other is relying on the average market salary for your position so you can get an idea about the appropriate amount.

Whichever method you choose, it is crucial to maintain accurate financial records and ensure that you have separate personal and business accounts.

Relying On an Owner’s Draw

An owner’s draw is money you take out of your company’s profits and is not subject to payroll taxes. The owner’s draw is the amount of money you, as your business owner, pay yourself from your business each year for basic expenses.

The IRS doesn’t require business owners to pay themselves a salary, but if they don’t, they may have to pay self-employment taxes on their net earnings from the company. This is why even self-employed people often allocate a salary for themselves.

The amount of the owner’s draw should be based on the needs of the business and the owner equally. It’s important to remember that taking too much out of your business can jeopardize its financial health.

The Best Way To Pay Yourself as a Business Owner – Factors To Consider

You need to think about a few things when deciding which payment method suits you best.

Type of Business Structure

As an owner, one of the first decisions you’ll need to make is what type of legal business entity your business will be. This decision will have significant implications for how much you’ll pay yourself and affect factors such as liability protection and tax treatment.

So, how do business owners get paid? In general, sole proprietorship and partnership offer the most flexibility when setting your salary, while corporations have more restrictions. 

Sole Proprietorship or Partnership

If you’re operating as a sole proprietorship, you can rely on the owner’s draw from the owner’s equity balance and business profits. The partnership also doesn’t allow a salary, as you are both a partner and an employee.

C-corp and S-corp

Both C-corp and S-corp allow you to set a salary for yourself. If you’ve set up a C-corporation, you can rely on salary and distributions. In the case of an S-corporation, you can pay yourself a market-rate wage as an employee and take dividend income as a shareholder.

Limited Liability Company (LLC)

An LLC is the only business structure where you can pick sides in the owner’s draw vs. salary debate. If you’ve established an LLC, you’ll again be both an employee and a company member. However, LLCs offer more flexibility in how profits are distributed, as according to the IRS, they can be taxed as a sole proprietorship, partnership, or corporation. 

How Much You Need vs. How Much Your Business Needs

Second, you must consider how much money you need to take out of your business each month. Taking funds in the form of a regular salary might be the best option if you only need a small amount. However, if you are trying to figure out how much you should pay yourself from your business because you need a larger sum, an owner’s draw might be a better option.

Another thing to consider is your current business situation. If the cash flow of your business has seen better days, then taking an owner’s draw might not be a good idea.

If you take too much money out of your business, you might reduce its profits and affect its performance negatively. This will mean you’ll get fewer profits in the long run and might have to dip into your own wallet to pay operating expenses down the line.

Understanding Tax and Compliance Implications Behind Paying Yourself From Your Business

When you are paying yourself, it is crucial to understand the tax rules of each payment method.

The sole proprietor and partner will have to pay self-employment tax, including Social Security and Medicare taxes. These taxes are also included in the salary withholdings if the business structure allows this kind of payment. Different implications apply to different types of businesses, so you should inform yourself about the right way to file taxes as a small business owner.

It is essential, especially if you are a small business owner, to get tax advice when figuring out what type of business structure would be right for you. You must understand how you will have to pay taxes with a specific business structure before you even get to your first tax report.

Mistakes To Avoid When Paying Yourself As a Business Owner

There are a few mistakes new business owners often make, so let’s take a look at how you can avoid them.

Make Sure You’re Not Overpaying or Underpaying Yourself

First, you must ensure you are paying yourself reasonable compensation. Consistency is the key here, and you should ensure that you are paying yourself the same amount at the same intervals.

While the owner’s draw might seem like a good idea initially, it often pays to leave money in your business account to cover unexpected expenses instead of drawing it for personal needs.

Calculate the Taxes Into Your Budget

You need to make sure that you comply with all the payroll and tax regulations when paying yourself as self-employed. You might have to pay penalties or get a sizable tax bill if you do not.

It’s advisable, especially for new business owners, to rely on accounting software to help you budget everything.

Not Paying Yourself at All

The third and final mistake to avoid is not paying yourself at all! While many new business owners initially hold out on receiving a salary, calculating the owner’s compensation into your operating budget should happen as soon as the business is profitable enough to allow it.

Conclusion

Figuring out how to pay yourself as a business owner is a difficult task, and you must consider several factors to find an optimal sum and compensation method.

It is always worth consulting with an experienced accountant and seeking advice before forming your business. They can help you avoid the most common mistakes and give some tips based on your specific situation.