Getting paid is the best part of owning a business, right? Not necessarily. There’s a lot of confusion surrounding the payment issue for business owners. How should you pay yourself? How do you know when it’s time to start paying yourself? And how do you calculate just how much you should pay yourself now that your business is finally a profitable venture?
We’ll cover these questions below. For now, congratulate yourself on reaching this point in your business venture. Many don’t make it this far, and the fact that you have shows that you’re onto something good! Don’t fret about paying yourself. You’ve worked for free long enough and now it’s time to collect the returns!
How Should You Pay Yourself as a Business Owner – Salary or Draw?
How is your company structured? If you’re a sole proprietor, scroll down to read the information in the Sole Proprietors and Partners section. If your company is structured as an S Corporation, you are required by law to receive regular paychecks that include withholdings for Medicare, Social Security, federal and any required state income taxes.
However, you also have the option to take additional payment, beyond your salary, in the form of a draw. Draws or distributions are written as checks that don’t withhold the taxes that a regular payroll check does. The problem with a draw is the eventual tax bill, but there are ways to ease that challenge.
Deciding how much to take as salary and how to much to take as a draw is difficult. We’ll walk you through it.
How much to take as a salary
The IRS says you must earn “reasonable compensation” for the type of work you’re doing. Use the salaries offered at other businesses for the same work as a guideline for your own salary.
But don’t get too hasty! Sheryl Schuff, small business CPA, says you should carefully consider the total amount your salary and draws will come to before cutting any checks to yourself.
“Owners of S Corporations have come under increased scrutiny the past several years, as they typically prefer to take draws rather than payroll to avoid paying the associated payroll taxes. It’s imperative for business owners to understand the position the IRS takes on reasonable compensation. One of the largest financial risks to entrepreneurs is penalties and interest for incorrect payroll-tax reporting.”
How much to take as a draw
How much should you take as a draw (checks with no tax withholdings)? The most important thing here is considering the tax bill you’ll eventually receive. Taking too much as a draw and not enough salary will send up red flags and could cause you to incur penalties and interest for incorrect reporting.
Developing a savings plan to add cash to each month will simplify that process. You can also make quarterly estimated tax payments. Schuff recommends coming up with both numbers – salary and draw – to ensure your needs are met without overly penalizing yourself at tax time.
Sole proprietors and partners
The rules are a bit different for sole proprietors and members of business partnerships. You are free to take the profits out of your business whenever you’d like sans payroll withholdings. The downside? You’ll basically pay the equivalent of that amount on your reported income taxes.
To avoid paying astronomical taxes at one time, small business owners should pay themselves a regular, scheduled salary. This makes it easier to establish the cost of running the company and clears up any questions the IRS may have about how much you pay yourself.