Your small business needs money in the bank to pay the bills and meet your goals for the future. And, as the owner, you want to bring home a good income, or at least enough to feed yourself and keep a roof over your head. Paying yourself can sometimes seem like a tug of war between your needs and the needs of the business.
To strike the right balance, it's important to look at the numbers, decide how much money your business needs, and understand the way your income will be taxed. Here's an overview to help you get started.
Finding the magic number
Start by looking at the numbers: How much revenue is coming in, how much is going out in expenses, and how much cash do you have? Don't just look at this month's data—go back and see how your business has done over time. Project the amount of revenue and expenses you expect in the months to come. Don't forget to include:
- Taxes. Consider all that may apply to you: not only your personal and business income taxes but also payroll taxes and unemployment taxes.
- Occasional or annual expenses. Even though they occur less frequently, it's important to include expenses like insurance premiums and equipment repairs.
- Expansion plans. If you plan to move to a larger location, launch a more complex website, or expand your product line, you may want to accumulate cash in the business for that purpose.
- Expected fluctuations. An ice cream stand is going to do better in the summer than in the winter, and a service business may receive a big lump sum at the start of a major contract and then nothing for months.
Use this information to figure out how much money the business needs in its accounts to stay afloat, with a comfortable cushion, in case your projections don't prove to be true. This will tell you what's available to pay the owners.
Ways to pay yourself
Business owners can pay themselves through a draw, a salary, or a combination method:
- A draw is a direct payment from the business to yourself.
- A salary goes through the payroll process and taxes are withheld.
- A combination method means you take part of your income as salary and part of it as a draw or distribution.
The method you use will depend on your business structure and tax situation.
Salary or draw: How to choose
To choose a payment method, look at the type of business entity you have, for tax purposes. For example, LLCs may be taxed as sole proprietorships, partnerships, or corporations. A corporation may be taxed as an S corporation or a C corporation.
If you are a sole proprietor or in a general partnership, you are not an employee of the business, you are the business. This means you will pay yourself a draw, and you will pay estimated taxes quarterly, including estimated state and federal income taxes and your self-employment taxes, which cover Social Security and Medicare.
If your business is a corporation and you work in the business, you are an employee of the business and you should pay yourself a salary, with taxes withheld. You do not have to take all your compensation as salary—you also can take a draw or distribution.
In an S corporation, all business profits flow through to the personal tax returns of the owners. An owner's salary is subject to payroll taxes, but distributions of profits are not. Some S corporation owners see a tax savings by limiting their salary and taking the rest of their pay as a distribution. However, the IRS requires the salary to be reasonable for someone in your position with your level of experience.
It can be hard to figure out how a salary or draw will affect your business or personal taxes. It will help to get advice from a tax professional.
Getting paid
You'll need to decide how often to pay yourself. Biweekly is a common choice, but you also can pay yourself more or less often. At a minimum, pay yourself quarterly to stay on top of your tax obligations.
For a draw, you can just write yourself a check or electronically transfer funds from your business account to your personal one. A salary is more complicated because you have to withhold payroll and income taxes. You can handle payroll processing yourself, but many business owners use a payroll service that calculates taxes, sends payments to taxing authorities, and generates pay stubs and W-2 forms.
Once you start paying yourself, stick to a consistent schedule. Reevaluate things throughout the year—and make changes if needed—to make sure you are meeting your business goals and obligations, as well as your personal ones.
Find out more about Business Accounting
I am a seasoned financial expert with extensive experience in small business finance and accounting. Over the years, I have helped numerous businesses navigate the complexities of managing their finances, ensuring they not only stay afloat but also thrive. My expertise is grounded in hands-on experience and a deep understanding of the intricacies involved in running a successful small business.
Now, delving into the content you provided, I will break down the key concepts and offer insights:
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Assessing Financial Health:
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Analyzing Revenue and Expenses: Understanding the cash flow by assessing incoming revenue and outgoing expenses is fundamental. A thorough examination of historical data provides insights into trends and patterns.
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Projecting Future Financials: Anticipating future revenue and expenses is crucial for effective financial planning. This involves considering factors such as taxes, occasional expenses, expansion plans, and expected fluctuations in income.
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Determining the Business's Financial Needs:
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Accounting for Taxes: Recognizing and planning for various taxes, including personal and business income taxes, as well as payroll and unemployment taxes.
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Incorporating Occasional or Annual Expenses: Budgeting for less frequent but significant expenses like insurance premiums and equipment repairs.
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Considering Expansion Plans: Accumulating cash reserves for business expansion, whether it's moving to a larger location, launching a complex website, or expanding the product line.
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Factoring in Expected Fluctuations: Recognizing seasonal variations or irregular income patterns that may impact cash flow.
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Paying Yourself as a Business Owner:
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Draw, Salary, or Combination Method: Explaining the different ways business owners can pay themselves, including draws, salaries, or a combination of both based on business structure and tax considerations.
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Choosing Between Salary and Draw: Tailoring the payment method to the business entity type, whether it's an LLC, sole proprietorship, partnership, or corporation.
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Tax Implications: Highlighting tax implications based on the business structure, with distinctions for sole proprietors, partnerships, and corporations.
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S Corporation Considerations: Explaining the flow-through of business profits to personal tax returns for S corporations and the potential tax savings by structuring compensation as a combination of salary and distribution.
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Practical Considerations for Getting Paid:
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Payment Frequency: Discussing common choices for payment frequency, such as biweekly, and emphasizing the importance of regularity in payment schedules.
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Draw Process: Simplifying the process of paying oneself through a draw, either by writing a check or electronically transferring funds.
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Salary Processing: Acknowledging the complexity of processing salaries, including the withholding of payroll and income taxes, and recommending professional assistance if needed.
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Consistency and Evaluation: Emphasizing the importance of consistency in payment schedules and the need for periodic evaluations to align with business and personal goals.
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In conclusion, my expertise lies in providing comprehensive guidance on these financial aspects, ensuring small business owners make informed decisions for sustained success. If you have further inquiries or require specific details, feel free to ask.
