A common question new entrepreneurs face whenever they start a business, such as opening a franchise, is how they should pay themselves. After all, when you have spent your entire life simply getting a check from your boss, it’s hard to know how to handle paying yourself once you become the boss.
For example, should you give yourself a salary or draw from the overall profits? What are the pros and cons of each method, and how can you navigate all the tax liability issues that arise when small business owners pay themselves?
Let’s take a look at the upsides and downsides of different ways to produce your paycheck.
Paying Yourself as a Business Owner: Salary or Draw?
Generally, owners of small businesses pay themselves in one of two ways. The first method is to give themselves a salary, which lets the owner receive a fixed income each month as they would have received payments as an employee. The second method is to draw from the overall profits of the company, which may give a business leader more flexibility but can be variable.
It can be difficult to decide between owners’ draw vs. salary for company owners because no two companies are alike. To help you decide for yourself, here is a break down of the pros and cons of each method and other important factors to consider.
Pros of Salary
Some benefits of using a salary for paying yourself as a business owner are more obvious than others. For example, this method is easiest to set up, and it’s often more convenient for paying your expenses because you know exactly how much you’ll get on certain dates.
A salary through your HR department or HR BPO partner means your state and federal taxes are automatically deducted, and cash flow management will be easier. While salaries have many benefits, though, it’s also important for modern entrepreneurs to know the cons of this business owner pay structure.
Cons of Salary
The primary con of paying yourself with a salary is that your expenses may fluctuate (and sometimes fluctuate wildly) over time, and such fluctuations make it difficult to reliably pay yourself the same amount. If your profitability goes down, you may not be making enough to pay yourself your normal salary.
Aside from those issues, most drawbacks of salaries involve navigating your taxes. Keep in mind that your dividends will be counted as income along with your salary, so you could tax yourself too much (just one of the many business owner tax liability issues you’ll face). You’ll need to understand the IRS’s idea of “reasonable compensation” because paying yourself too much could get you and your company audited.
Pros of Draw
The primary benefit of drawing from business profits to pay yourself is that it gives you added flexibility as you manage your business. For example, you can adjust how much you pay yourself as profits go up or down, and you can either draw regularly (making this more like a salary) or draw on it when you need to (which is great for companies with a low or unreliable cash flow).
Draw is usually the ideal method for business bosses trying to establish themselves and any company whose profits fluctuate significantly across different seasons. Established companies with a steady stream of profits throughout the year may have owners better off receiving a salary.
Cons of Draw
Some cons of drawing from your profits include that you can’t contribute to a 401(k) except via a salary, so this isn’t a great option for those planning for their retirement with this type of pension account. This method may disrupt your cash flow as well, and it requires you to be a careful planner. It’s easy to accidentally overdraw or make errors when budgeting, just as it’s easy to make mistakes when planning taxes.
Tax issues represent the biggest con for drawing from your profits because legal compliance with IRS regulations can be difficult and confusing. For example, you’ll need to self-report taxes quarterly when you draw, and if you own a C corporation, this payment method may cause you to get double-taxed for both your profits and dividends.
Owners Draw vs. Salary for Business Owners: Which Method Is Best?
There are pros and cons to both methods of paying yourself as a business owner. How can you decide which method is best for you?
The type of business you own may dictate your decision. For example, if you have an LLC, a partnership, or a sole proprietorship, you can take an owner’s draw, and if you have a corporation or an LLC taxed as a corporation, salary is usually the better method.
Otherwise, your decision mostly comes down to how mature your company is and how your finances look. For example, you are likely to make nothing when you start a company because you are still building your brand, and when you do start making a profit, you must determine if the cash flow is regular enough for a salary or if you need to retain the flexibility of drawing.
Finally, you can’t afford to neglect your finances, including obligations such as your mortgage or your car payments. Ultimately, you’ll need to choose a payment structure that fits both your personal and business needs.
Reach Your Full Potential as an Entrepreneur Today!
Now you know how to determine the best method of paying yourself as a business owner. But do you know who can help you reach your full potential as an entrepreneur?
Here at Confie, we specialize in helping enterprising entrepreneurs turn their most ambitious dreams into a profitable reality. To discover what we can do for you and your ambitions, you can call (714) 252-2500 or just use this form to contact us today!
