While we all have different reasons that made us decide to start a business, the truth is that we also need to make a living. Working for free is not a likely option for most business owners, but figuring out how to get a paycheck from your business can be challenging, especially in the early years.
With that in mind, let’s discuss the differences between an owner’s salary and an owner’s draw.
What is an Owner’s Draw?
An owner’s draw is when a business owner takes funds out of their business for personal use, and this can occur with a sole proprietorship, partnership, or a limited liability company. Business owners might opt to use a draw for compensation versus a salary. Draws are usually taken from the owner’s equity account.
What is a Salary?
An owner’s salary is a fixed amount paid to you on a regularly scheduled pay period. The amount of your salary will depend on your business type, your role in the company, and your experience.
Pros and Cons of a Salary
The pros of taking a salary include:
- Stable income
- Employee benefits
- Tax benefits
- Professionalism
The cons of taking a salary can include:
- Reduced flexibility
- Impact on equity
- Uncertainty of pay
- Tax implications
For many business owners, taking a draw versus a salary means that you can lower the tax liability for the whole business, but you might not find that you can take a significant draw on a regular basis.
Before you choose to opt for a salary or a draw will depend upon your business structure, understanding of owner’s equity, and the potential tax implications.
Owner’s draws are not taxable on the business income, but it is taxable as income on the owner’s personal tax return, which means you have to pay estimated taxes and self-employment taxes.
How to Pay Yourself from Your Business Account
Sole Proprietorship
To pay yourself as a sole proprietor, you need to set up a business bank account, transfer money from your business bank account to your personal one, and then record the transaction.
You cannot use a salary to pay yourself in a sole proprietorship, so you will have to make sure to pay the appropriate taxes based on the funds transferred into your personal account, either through a check or electronic method.
Partnership
With a partnership, you complete the same withdrawal from the owner’s equity account and record the transaction. However, you need to follow the process outlined in the partnership agreement to complete the draw. As with other draws, you will need to be aware of the tax implications.
Limited Liability Company (LLC)
A limited liability company (LLC) can follow a similar draw structure as outlined in the previous sections, thus allowing the owner to make draws in a timely fashion. However, there are additional tax implications, which should be discussed with your accountant.
S-corporation (S-corp or small corporation)
The IRS requires S-corp owners who serve as employees or officers to pay themselves reasonable compensation. However, they cannot take a draw from the owner’s equity. Typically, they would be paid dividends on their shares in the company.
C-corporation
A C-corporation does not allow owners to take a draw from the equity account, although they may be allowed to receive dividends. The IRS also requires them to be paid reasonable compensation if they serve as an officer or an employee.
How Do You Determine Fair Compensation?
To determine what is fair and reasonable compensation, you should research statistics for average small business owner salaries and narrow it down to your industry.
Calculate reasonable compensation based upon your responsibilities and the amount of time devoted to the position. Document the reasons for your compensationn in the minutes of your board of directors’s meeting.
Avoid paying compensation proportional to the stock owned by the shareholders, since that could be perceived as a disguised dividend by the IRS. The IRS also provides 9 factors that can help you to determine reasonable compensation.
What Are the Tax Implications of Owner’s Draw vs Salary?
Sole Proprietor
As a sole proprietor, you can only receive income from your business through an owner’s draw. You would need to make payments to the IRS throughout the year to meet your tax obligations and report the draws as income on your tax return.
Partnership
The tax implications for the partnership mean that you are reducing the amount of business equity available, thus reducing the tax burden of the business. However, you will still be responsible for paying taxes on your individual return, and must follow the procedures for draws as outlined in the partnership agreement.
Limited Liability Company (LLC)
A limited liability company (LLC) can give you the advantage of being an employee, allowing for taxes to be withheld out of your check. If you opt to take an owner’s draw, then you will need to pay the taxes by making payments throughout the year to the IRS.
S-corporation (S-corp or small corporation)
You cannot take a draw from an S-corp, which means you will need to have a salary. However, you enjoy the tax benefits of having your taxes withheld from your paycheck and other employee benefits. If you receive a dividend, then you would be responsible for paying the taxes owed on that dividend as part of your personal income tax.
C-corporation
Since the owners cannot take draws, they would have to be salaried, and taxes would be withheld from the paychecks. However, paying dividends to the owners can help to reduce the overall tax liability of the company.
What Are the Advantages and Disadvantages of Using an Owner’s Draw vs Salary?
An owner’s salary can be incorporated into the overhead of the business while also allowing the owner to have taxes withheld as part of their employee benefits. Payments for federal, state, local, Social Security, and Medicare are automatically taken out of your paycheck.
Plus, because your company is paying half of your Social Security and Medicare taxes, you will only pay 7.65%, which is half of what you will pay if you take an owner’s draw.
The way you are taxed on your income can influence whether you choose to take a salary or an owner’s draw. Depending on the structure of your business, taking a salary may result in more taxes being withheld at the source, whereas taking an owner’s draw may require you to pay estimated taxes.
Frequently Asked Questions
Is there a legal requirement for the amount of owner’s draw or salary?
The IRS requires that a salary be reasonable compensation. There are no requirements regarding the size of a draw, but taxes will need to be paid by the owner for the draw. You need to keep track of the amount taken in the draw for tax purposes.
Can business owners receive both a salary and an owner’s draw?
Yes, they can opt to take both, but they need to be aware of how it can impact the cash flow of the business.
Can the owner’s draw be taken at any time?
Yes, as long as the funds are available.
Are there any legal restrictions on the frequency of salary payments?
Pay frequency laws are governed on a state-by-state basis, and federal law requires that they be consistent.
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And here’s some free resources:
In Summary
If you are opting to work for your company, there are several options that you can utilize to get paid, including a salary, owner’s draw, or a combination of them both.
To determine the best option, you need to look at your business model, cash flow, and other factors to maintain the financial health of your business while still making sure you are paid a reasonable compensation for your efforts and work.
