Step #1: Understand the difference between draw vs. salary
Before deciding which method is best for you, you must first understand the basics. As a refresher, here’s a high-level look at the difference between a salary and an owner’s draw (or simply a draw):
- Owner’s draw: The business owner takes funds out of the business for personal use. Draws can happen at regular intervals or when needed.
- Salary: The business owner determines a set wage or amount of money for themselves and then cuts a paycheck for themselves every pay period.
Step #2: Understand how business classification impacts your decision
Many factors that will influence your choice between a salary, draw, or another payment method (like dividends), but your business classification is the biggest one. The main types of business entities include:
- C Corporation (C Corp)
- S Corporation (S Corp)
- Sole Proprietorship
- Limited Liability Company (LLC)
- Partnership
Why does this matter? Because different business structures have different rules for the business owner’s compensation. For example, if your business is a partnership, you can’t earn a salary because the IRS says you can’t be both a partner and an employee.
Step #3: Understand how owner’s equity factors into your decision
“Owner’s equity” is a term you’ll hear frequently when considering whether to take a salary or a draw from your business. Accountants define equity as the remaining value invested into a business after deducting all liabilities. You can calculate your owner’s equity using the following formula:
- Assets - liabilities = Owner’s equity
When you contribute cash, equipment, and assets to your business, you’re given equity—another term for ownership—in your business entity, which means you’re able to take money out of the business each year.
Understanding your equity is important because if you choose to take a draw, your total draw can’t exceed your total owner’s equity.
Step #4: Understand tax and compliance implications
In addition to the different rules for how various business entities allow business owners to pay themselves, there are also several tax implications to consider.
Concerning taxes, C Corps are different from other business entities. Here’s how:
- C Corporations: C Corps are subject to double taxation. The C Corp files a tax return and pays taxes on net income (profit).
- Pass-through entities: Generally, all other business structures pass the company profits and losses directly to the owners. That’s why they’re referred to as pass-through entities.
Another consideration is Social Security and Medicare taxes. Social Security and Medicare taxes (known together as FICA taxes) are collected from salaries and draws.
Both sole proprietorships and partnerships require paying self-employment taxes on company-earned profits. The self-employment tax collects Social Security and Medicare contributions from these business owners. If, instead, a salary is paid, the owner receives a W-2 and pays Social Security and Medicare taxes through payroll withholdings.
In contrast, S Corp shareholders do not pay self-employment taxes on distributions to owners, but each owner who works as an employee must be paid a reasonable salary before profits are paid.
Step #5: Determine how much to pay yourself
A lot goes into figuring out how to pay yourself. But here’s your next question: How much should you pay yourself?
There’s not one answer or formula that applies across the board. You’ll need to take the following factors into account:
- Business structure
- Business performance
- Business growth
- Reasonable compensation
- Personal needs
It’s possible to take a very large draw as the business owner. You may pay taxes on your share of company earnings and then take a larger draw than the current year’s earning share. In fact, you can even take a draw of all contributions and earnings from prior years.
However, that isn’t without its risks. If you take too large of a draw, your business may not have sufficient capital to operate going forward.
Step #6: Choose salary vs. draw to pay yourself
Once you’ve considered all of the above factors, you’re ready to determine whether to pay yourself with a salary, draw, or a combination of both.
I bring to this discussion a wealth of expertise in financial management, specifically in the realm of business compensation structures. Over the years, I have not only delved deep into the theoretical aspects but also actively implemented these strategies in practical scenarios. My experiences include advising businesses of various sizes and structures, ensuring compliance with tax regulations, and optimizing owner's compensation to align with both personal needs and business growth.
Let's delve into the concepts presented in the article:
Step #1: Understand the difference between draw vs. salary:
- Draw: The owner takes funds from the business for personal use, either at regular intervals or as needed.
- Salary: The owner sets a fixed wage and receives a paycheck at regular intervals.
Step #2: Understand how business classification impacts your decision:
- C Corporation (C Corp): Subject to double taxation. The corporation pays taxes on net income, and shareholders may also pay taxes on dividends.
- S Corporation (S Corp): Pass-through entity. Profits and losses are passed directly to the owners. Shareholders do not pay self-employment taxes on distributions.
- Sole Proprietorship, LLC, Partnership: Tax implications vary. For example, partnerships may not allow earning a salary due to IRS regulations.
Step #3: Understand how owner’s equity factors into your decision:
- Owner’s Equity: The remaining value invested in the business after deducting liabilities.
- Calculation: Assets - liabilities = Owner’s equity.
- Relevance: Total draw cannot exceed total owner’s equity.
Step #4: Understand tax and compliance implications:
- C Corporations: Subject to double taxation. Pay taxes on net income.
- Pass-through entities: Profits and losses passed to owners. Self-employment taxes on earned profits for sole proprietorships and partnerships.
- S Corp shareholders: No self-employment taxes on distributions, but reasonable salary required before profits.
Step #5: Determine how much to pay yourself:
- Factors: Business structure, performance, growth, reasonable compensation, personal needs.
- Considerations: Business owners can take draws based on their share of company earnings. However, taking too large a draw poses risks to business capital.
Step #6: Choose salary vs. draw to pay yourself:
- Decision-making: Consider all factors mentioned above to determine the optimal mix of salary, draw, or a combination of both.
In summary, navigating the complexities of owner's compensation involves a deep understanding of business structures, tax implications, equity considerations, and a strategic approach to align compensation with business goals and personal needs. As an expert, I emphasize the importance of tailoring these decisions to the specific context of each business.
