Owner Draw Vs Salary: Paying Yourself As An Employer
As a new business owner, having enough money to run your business is always a top concern. While it takes on average about $3,000 to start a microbusiness, meaning one with up to nine employees, you’ll also need cash on an ongoing basis to cover payroll and other organizational expenses.
Since it can be challenging to predict your cash flow, you may be wondering about the best way to pay yourself and still have enough money left over to cover your costs.
Complete Payroll Solutions helps thousands of start-up businesses throughout the Northeast with their payroll needs as an outsourced payroll provider. A common question we get from new small business owners is whether it’s better to put themselves on the payroll and be paid a salary or take what’s known as an owner’s draw.
Here, we’ll cover the differences between the two approaches in several areas:
- Type of business you run
- The amount of equity you have in the business
- Tax implications
- How much you pay yourself as a business owner
After reading this article, you’ll understand the factors to consider when deciding whether to take a salary or owner draw and what is the better option for your business.
How do business owners get paid?
The two most common ways for business owners to get paid is to either take an owner’s draw or receive a salary.
With an owner’s draw, you’ll take money from the business’ profits, or capital you’ve previously contributed, by writing yourself a check or depositing funds into your personal bank account. You can take fixed draws at regular times or as needed. Since owner draws are discretionary, you’ll have the flexibility to take out more or fewer funds based on how the business is doing.
A salary, on the other hand, is a set, recurring payment that you’ll receive every pay period that includes payroll tax withholdings. When deciding what to pay yourself, you’ll want to take into account your expected profit and expenses. As your circumstances change, you can always give yourself a raise or take a pay cut if needed.
What is the best way to pay yourself as a business owner?
When you’re evaluating the best method to pay yourself, there are several factors to consider.
The Type of Business You Run
Your company’s legal structure is the biggest factor when it comes to deciding whether to pay yourself a salary or take an owner draw since you may be limited in your choices based on how your business is set up.
For example, if you run a partnership, you can’t pay yourself a salary because you technically can’t be both a partner and employee. In this case, you’d need to take an owner’s draw. While partners often split income evenly, that doesn’t have to be the case so you can arrange a different income draw based on your partnership agreement.
Likewise, if you’re an owner of a sole proprietorship, you’re considered self-employed so you wouldn’t be paid a salary but instead take an owner’s draw. Single-member LLC owners are also considered sole proprietors for tax purposes, so they would take a draw.
On the other hand, owners of corporations or S-corporations generally can’t take a draw and would typically be paid a salary instead. Just remember that if you own an S-corporations, your salary must be considered reasonable compensation, which we’ll discuss in a bit.
The Amount of Equity You Have in the Business
If you plan to take an owner’s draw, it’s important to understand that the amount of your total draw for the year can’t be more than the equity you have in the business.
Your equity is defined as the amount of accumulated value you’ve invested into the business through things like cash, equipment, and other assets.
While you can opt to take out all the equity in your owner’s draw, you’ll have to consider the impact that could have on your business’ continued operations and whether that would allow you to pay your expenses and invest in future growth.
When you take an owner’s draw, no taxes are taken out at the time of the draw. However, since the draw is considered taxable income, you’ll have to pay your own federal, state, Social Security, and Medicare taxes when you file your individual tax return. The tax rate for Social Security and Medicare taxes is effectively 15.3%.
If you take a draw, you may be responsible for making quarterly estimated tax payments as well depending on what you’ll expect to owe in taxes for the year.
If you pay yourself a salary, like any other employee, all federal, state, Social Security, and Medicare taxes will be automatically taken out of your paycheck. Because your company is paying half of your Social Security and Medicare taxes, you’ll only pay 7.65% ‒ half what you’ll pay if you take an owner’s draw.
While you’ll still be paying these taxes as the business owner, the advantage of being a salaried employee is that you won’t have to worry about calculating and paying the taxes at tax time. And your salary is treated as a business expense, which can reduce your company’s net income.
Keep in mind that if you’re an S-corporation owner, you may also have to report pass-through profits on your tax return in addition to the salary you receive from the corporation.
How Much You Pay Yourself
No matter what option you choose, you’ll want to be mindful of your business’ current and future expenses and pay yourself in a way that allows you to be able to take care of your liabilities.
As we already talked about, your only limit on the amount of an owner’s draw is that your total take for the year can’t be more than your equity in the business.
With a salary, you can decide on any wage to pay yourself. However, as we discussed earlier, if you own an S-corporation, your salary must be considered reasonable compensation.
There are no specific guidelines for what constitutes reasonable compensation. However, the IRS says training and experience, duties and responsibilities, time and effort devoted to the business, what comparable businesses pay for similar services, and payments to non-shareholder employees are factors to consider. It’s important to carefully consider these in determining your salary to avoid an IRS audit.
So, Should I pay myself a draw or salary?
Paying yourself is just one of many expenses you’ll have as a new business owner. And figuring out how to compensate yourself can be tricky. It’s important to weigh the legal guidelines and varying levels of risk and liability associated with the different business structures as well as what makes the most sense for the business in deciding whether to take a draw or be a salaried employee.
If you’re able to choose freely between the two options, generally speaking, an owner’s draw is best if you:
- Want more flexibility in what and when you pay yourself based on the performance of the business
- Are unsure of what your cash flow will be
A salary is a better fit if you:
- Don’t want to worry about calculating taxes on your pay
- Want more stability with your paycheck
- Believe it’s easier to have a set salary for tracking expenses and managing cash flow
As you get your new business up and running, your owner compensation is one of the things you’ll need to consider to make sure you meet your legal obligations and stay in compliance. Visit our resources page for all the forms you need to start your business off right, starting with applying for an Employer Identification Number.