Owners often get the blame first when a business goes belly up but the last to get paid when it’s profitable. The fact that you may not be on the employee payroll may only add to your confusion about how to pay yourself.
Before payday rolls around, read up on how to pay yourself as a business owner.
The two main ways business owners can pay themselves are through an owner’s draw or a salary. Owners of firms with certain business entities can do a combination of both. Let’s take a look at both of these options in greater detail.
An owner’s draw is a withdrawal a business owner takes from the company for personal use. The withdrawn funds usually represent a distribution of profits the business generated. But they could also be a reimbursement of capital the owner infused into the company in the past.
The benefit of compensating yourself via an owner’s draw? You can take one at any time. Thus, you can time withdrawals to when the company is bringing in revenue. This option is an immense advantage for seasonal businesses with cash-flow inconsistency.
The downside is that taxes are not withheld at the time of withdrawal. Hence, you would still need to pay estimated taxes on owner’s draws. Plus, an owner’s draw is not eligible for deduction as a business expense. You could also lose ownership share in a partnership or corporation by taking an owner’s draw. Or, you could put a dent in the business’s valuation with large withdrawals.
A salary equates to an annualized amount doled out on a recurring basis in fixed payments. Bimonthly payment periods are common. Business owners, in essence, pay themselves like W-2 employees when they take a salary.
The main advantage of a salary is that withholding of taxes occurs at the time of payment. You can also deduct the wages of a business owner as a business expense. Moreover, you get a steady income year-round.
It could also benefit your retirement. In the case of an S-corp, you can only make contributions from a salary (not an owner’s draw) to a 401(k).
But you wouldn’t have the flexibility to pay yourself whenever you want. This alternative is bad news for a cash-flow-inconsistent business. Why? Your salary may take valuable capital out of the company when you need it most.
Not all payment means mentioned above are all available to owners of firms of all business entities. So how do you know which method your business can use?
Here are general guidelines on how to pay yourself as a business owner for each business entity type.
Now, you know how to pay yourself as a business owner. But exactly how much should you pay yourself as a business owner?
An owner has discretion over how much he takes in the form of an owner’s draw. But you should consider how the draw affects the business when settling on an amount. Think about how it affects taxes, working capital, business value and equity stake.
Pulling a salary? Corporate shareholder-employees must take a salary that is “reasonable” to qualify for a deduction. The IRS notes that reasonable pay is what a similar firm would pay for services of the sort you provide.
Thus, an S-corp shareholder-employee can’t take zero wages to avoid payroll taxes. Likewise, C-corp shareholder-employees must avoid taking too high a salary. Otherwise, they risk having the excess part of their salary treated as dividends. These dividends aren’t deductible.