Hi everyone, I’m Bette Hochberger, CPA, CGMA. Today we will discuss how to pay yourself as a business owner. If you’ve just started your own business, you must consider how your profits translate into official income. How you pay yourself as an entrepreneur depends on the type of small business you’ve created and how you’d want to handle those tax implications of your income. So, you have a couple of options. Let’s jump in and talk about them.
The Owner’s Draw Method
This method is where you draw funds from your business profits when you need or want them. You have a lot of flexibility about when you take funds and how much, which can easily accommodate various cycles in business income.
Pros & Cons
As mentioned above, this method comes with plenty of flexibility, allowing you to adjust your compensation based on how your business is doing financially. Pretty great, right? But this method has a downside- it comes with a lot of paperwork. With the owner’s draw method, you must report profits as business income and pay self-employment taxes. In addition, you’ll need to keep the IRS in the loop through quarterly estimates and filings. The owner’s draws are not considered or taxed as personal income. So, you will have to calculate the actual business profits. You must also plan and pay quarterly taxes depending on your draw. This might add additional bookkeeping and accounting duties for a business owner.
The Salary Method
This method allows you to set up your business accounting to pay yourself a regular salary, just like any other employee. This gives you a steady, predictable income from your business. In addition, once your salary is set up, state and federal income taxes are automatically deducted from your check.
Pros & Cons
On top of having a steady and predictable income from your business, you’ll also have a history of regular paychecks should you need that evidence for a mortgage or other line of credit. Paying yourself a set amount every month also makes it much easier to track your business finances. This requires less paperwork and business capital fluctuation than the owner’s draw method. You can also adjust your salary or pay yourself a bonus at the end of the year, which is great.
The downside to the salary method is the research it can take to settle on the correct salary. The amount must satisfy the IRS’s “reasonable salary” rules. Your salary should be comparable to someone in a similar position in an equal company. Your income should match standard industry pay. With this method, you must consider how you set this up. But it’s overall the best one to go with.
Sole Proprietors, Partnerships, LLCs and S-Corps
Now, if you’re a sole proprietor, partnership, or LLC, you most likely will want to use the owner’s draw method. As a sole proprietor or a single-member LLC, you can take as much money from your company as you’d like, provided your business remains manageable. There are no partners or shareholders to consider to accommodate your payment structure or decisions. Also, if you are a single-member or multi-member LLC, you will have to use the draw method since LLC members are not allowed to pay themselves a regular salary.
If you are a member of a partnership or a multi-member LLC, you will need to split revenue between partners. In a partnership, your income distribution between partners should be outlined in your partnership agreement. This might be a 50/50 split, 60/40, etc., depending on the structure of your business. Most importantly, you must follow the plan in your partnership agreement and make sure the partnership files a Schedule K-1 with the IRS at the end of the year to show the owner’s draws along with the business profits, expenses, losses, credits, and deductions.
If you’re an S-Corp owner, you must use the salary method since the IRS is typically very interested in corporations’ salaries. The reasonable salary requirement states that business owners must be paid “an amount that would ordinarily be paid for like services by like organizations in like circumstances.” This means you’ll need to benchmark your salary using the salaries of other owners of companies like yours.
I hope you learned something new today. If you need help figuring out which method is best for you, feel free to schedule a meeting with me, and I’d be happy to help. As always, stay safe, and I will see you next time.