Having high cash inflows than outflows is the goal of any business manager. However, it can be challenging for those running profitable enterprises to figure out how to reward your efforts as a business owner. It is essential to be mindful and cautious about any cash outflows from your business. Generally, business owners reward themselves in two major ways a salary or owner’s drawings. Let’s explore the salary vs. owner’s draw comparison and the top considerations when deciding which option is suitable for you and your business.
Salary vs. owner’s draw: Understanding the difference
To figure out which option is right for your business, we must first understand how each option works. Below is an overview of the key differences between a salary and an owner’s draw.
Here the business owner sets a wage for themselves, which they receive at each pay period typical to how a business compensates employees. A salary is a legal requirement for any limited liability company that pays tax as a corporation. In such situations, an oversight authority such as the IRS offers guidelines on reasonable compensation to ensure comparability of wages among people doing similar jobs in the same industry.
Here, the business proprietor makes cash drawings to meet personal needs, preferably from the business profits. The draws can occur at planned intervals or on an as-needed basis. However, limits apply too; as a business owner, you can only draw up to the amount you’ve invested in your business.
We will dig deeper about salaries and owners’ draw in later sessions. Next, you need to understand how business classification influences your reward options.
How business classification affects how you pay yourself
Business entities fall under one of the following classifications
• Sole proprietorship
• LLC (Limited liability company)
• C corporation or S corporation
Your specific classification will dictate how you pay yourself as a business owner. Each classification has unique rules for compensating business owners. Owners who run a sole proprietorship, partnership, or a limited company can reward themselves through a draw. In contrast, salaries are more appropriate for owners running corporations and limited companies taxed as corporations.
How owner’s equity influences your decision making
In accounting terms, owner’s equity refers to the value of a business after deducting liabilities. If an entity converted all its assets to cash and settled all its debts, the remaining cash would be the owner’s equity. Every business owner should keep track of their equity balance because it bears significance in your salary Vs. Cash drawings decision.
Equity holders can draw money from a business to reward their efforts. However, it’s important to note that you can only draw up to your total equity holding if you choose the draw option.
How tax affects your payment decisions
While guidelines exist for businesses on rewarding their owners, it helps to consider tax implications for both options. The C corporation often has unique tax implications that don’t apply to the other business classifications.
Unlike all other business classifications, C Corps are subject to double taxation. Each year, the entity files a tax return and pays corporate taxes based on net income. After settling taxes, C Corp owners can plow back the after-tax earnings to the business or pay dividends to the shareholders. In a dividend payout, the dividend income will be consolidated with other income sources when filing personal tax returns.
Pass-through business entities
Pass-through entities are those that distribute profits and losses to owners directly. These entities are not subject to double taxation. Partnerships, sole proprietorships, and other business structures fall under the pass-through umbrella.
How to pay yourself as a sole proprietor
Sole proprietors can pay themselves by making cash drawings from the business. As a sole proprietor, your owner’s equity balance rises when you contribute capital to the business and when the entity makes a profit. Your equity balance diminishes whenever you draw cash and when the business makes losses. Remember to set aside a portion of your draws in a separate account to cater for your tax liabilities when they fall due.
How to pay yourself in a partnership
In a partnership, the ownership is split between several owners based on their capital contribution. Like a sole proprietorship, the owner’s equity in a partnership increases whenever you inject capital and when the partnership is profitable and declines after each draw, and when the entity makes losses.
Because partners are not employees, they can’t earn a salary. However, a partner can earn a guaranteed payout for services offered to the partnership. The partnership will then adjust its profit with the payout amount. Similar to a regular wage, the payout is reported to the partner, who then pays income tax on the payout.
How to pay yourself from an LLC?
Laws governing the incorporation of limited companies may differ from state to state, but their mode of operation is essentially the same. LLCs can pay their owners through drawings or salaries depending on their tax structure. Limited liability companies can be taxed as a corporation, partnership, or sole proprietor business.
When taxed as a sole proprietor, the owner makes cash drawings from the LLC’s profits. When taxed as a corporation, the owner earns a regular salary alongside any proceeds from a dividend payout. In summary, paying yourself as an LLC depends on how the tax authorities view the entity.
Paying yourself as an S corporation
S corporation owners will typically pay themselves a salary the same way as other employees. The owner would have to set a reasonable compensation based on the services they offer the corporation. The owner’s salary should match the earnings of other professionals in similar positions.
The salary will appear as an expense on the entity’s books, while the owner will pay income tax on the wages. Many S Corp owners prefer to earn modest salaries if the corporation is still young in the industry.
How much to pay yourself as a business owner?
Once you decide between a salary and a draw, you will need to figure out how much to pay yourself. Below are the top factors to consider when setting your compensation package.
Regardless of which option you choose for rewarding yourself as a business owner, the compensation package will likely vary based on the entity’s performance. Remember to adjust your earnings to mirror your business’s performance. As a business owner, it’s advisable to pay yourself from the entity’s profits rather than the gross revenues.
2. Business phase
Owners should also consider the business phase when deciding how to compensate themselves. Many owners may prefer to postpone earning a salary for newly established ventures. If you are running a start-up venture or a business in its high growth stage, it’s advisable to reinvest the profits rather than pocketing the earnings.
3. Your personal expenses
Even though you own a business, you likely have personal expenses ranging from rent, mortgage, insurance premiums, loan deductions, and savings targets. Consolidating all your expenses allows you to estimate how much you should draw from the business.
4. Reasonable pay guidelines
If you are going to pay yourself a salary, it’s worth figuring out what a reasonable wage looks like in your industry for a similar position. Paying yourself a very high or low salary will raise red flags among tax authorities.
Pros and cons of taking a salary
• Simplifies administrative work
Receiving a salary takes care of your tax liabilities because taxes are automatically deducted from your gross salary. More importantly, taking a salary simplifies the process of tracking incomes against expenses.
• Limited choices in adjusting earnings
While it’s still possible to adjust your earnings depending on your entity’s performance, what you take home should still fall within the reasonable package criteria set by the Internal revenue service (IRS). What’s more, it can be challenging to decide how much to pay yourself when you opt for a salary.
Pros and cons of opting for an owner’s draw
• Earnings flexibility
Rather than confining themselves to a predetermined compensation package, business owners who settle for the draw option vary their payouts depending on their business priorities and personal needs.
• Drawings reduce owner’s equity
The biggest drawback of making cash drawings is reducing the owner’s equity holdings. Every cash drawing you make reduces the available funding for future business expenditures.
• Overdrawing hurts the business
Though owners are at liberty to draw up to their equity balance, drawing large amounts will hurt your business. Overdrawing may leave your business with inadequate capital, thus threatening the going concern status of your venture.
Rewarding yourself through SwiftBooks
At SwiftBooks, we understand the importance of rewarding yourself as a business owner. Our accounting platform makes it easy to track important business metrics that influence how business owners pay themselves. In addition to streamlining your bookkeeping and accounting practice, SwiftBook accounting will also help with your payroll and tax compliance.
Get in touch with one of our experts for a free quote on any of our accounting packages. Book an appointment with us today to learn more about our package options.https://swiftbooks.co/wp-admin/media-upload.php?post_id=3298&type=image&TB_iframe=1