March 21, 2023
How to Pay Yourself as a Small Business Owner
What you’ll learn
- How to legally pay yourself based on your business structure
- Pros and cons of paying yourself from your business
- Factors to consider when deciding how much to pay yourself
So you started a business and you’re bringing in some cash—congrats! But you have a bunch of questions about how to operate going forward, including how much to pay yourself.
While owning a business is inherently risky, it’s even riskier not to set aside a salary for yourself in the budget. But according to Business News Daily in 2016, only about half of business owners (51%) pay themselves a salary.
As a business owner or freelancer, it’s essential to find a balance that keeps your business profitable while also providing for your personal needs. How you pay yourself will depend on a few factors such as your business structure and goals. Let’s dive in!
Paying yourself as a business owner
Business owners typically get paid through a salary or a draw. A salary is a fixed amount of money paid at regular intervals. You’ll see taxes taken out of every paycheck. This is the most common method of payment for businesses that run as corporations or LLCs.
The main advantage of a salary is predictability. You always know how much money will go into your personal accounts every month, making it easier to budget personal and business finances.
The downside, however, is that your salary is extremely rigid. The IRS has a ‘reasonable compensation’ rule which states that your salary must be in line with others in your industry. Your business has to adhere to this rule even when times are lean.
A draw works differently. It’s money taken out of the business when needed. Taxes are due when you pay your tax bill, and setup doesn’t require as much paperwork as a salary. A draw is a popular payment method for business owners operating as sole proprietors or partnerships.
The biggest advantage of taking a draw is the flexibility. You can take more or less depending on the financial needs of your business.
The downside to taking a draw is that it takes time to understand and track all of the associated taxes.
Taxes are immediate
Easier to manage finances
Easy to set up
No immediate employment taxes
No delay when accessing funds
Can take from business as needed
Subject to employment taxes
Loads of paperwork
Must follow Reasonable Compensation rules
No predictable paychecks
Harder to manage finances
Must save money for tax bill
What is the right choice?
When deciding which method to use for paying yourself, consider your business strategy and financial needs. Taking a draw might be more beneficial if you’re just starting out and your business is not very profitable yet, but a salary might make more sense if you’re already established.
How to pay yourself legally
Understanding the different methods of paying yourself when you own a business is important for ensuring you comply with all tax laws and regulations. Knowing your options can help you make the most informed decisions about structuring payments for yourself and other employees. Below you’ll find how to pay yourself legally in each of the most common business structures.
How to pay yourself as a sole proprietor
If you’re the sole owner of your business, you aren’t required to pay yourself a salary. The simplest way to pay yourself is through distributions or draws. You can distribute funds from your business whenever necessary, and there are no set rules for how much to take. Having said that, you’ll need to prepare for quarterly and year-end taxes based on the amount you take.
How to pay yourself as an LLC
When you own an LLC, you have flexibility regarding the method by which you pay yourself, how much you earn, and how often.
You can take regular draws from your profits if your business is taxed as a sole proprietorship or partnership. You can pay yourself a salary if you’re structured as a corporation.
How to pay yourself as an S-Corporation
S-corporations are popular with small businesses and freelancers because they provide different tax advantages than sole proprietorships and LLCs. If you operate as an S-corp owner, you can pay yourself a reasonable salary, and any additional profits can be taken as a draw.
Deciding how much to pay
Once you’ve decided how to pay yourself, the next step is deciding how much. To do this, consider both your business and personal needs. Monthly expenses, savings goals, business growth plans, and taxes should all factor into your decision.
According to Payscale, the average small business owner makes around $63K per year. An example of a reasonable monthly salary or draw for a small business owner would be anywhere from $2,000 to $5,000.
To determine a reasonable monthly salary or owner’s draw, calculate your monthly business expenses and subtract that from your monthly income. This will give you a better idea of how much money you have left to pay yourself. Make sure to consider your personal monthly expenses before settling on a final number to make sure you can meet all your needs as well.
Avoiding common payment mistakes
There are some common mistakes to avoid when paying yourself as a business owner.
Trying to budget for personal and business taxes can be tricky. If you underestimate how much money you need to set aside and end up with an unexpected bill, it can put an extra financial strain on your business. To avoid this, make sure you’re setting money aside each month to cover both your tax obligations at the end of the year. If you want to make sure you’re really following all legal requirements, meet with a tax professional to set up a plan.
Don’t jump to take large sums of money out of your business, as this can create an imbalance in cash flow and put you at risk of not being able to pay your regular expenses. Save your large draws for a time when they won’t significantly disrupt the financial health of your business.
Create a consistent payment schedule for your earnings so that you can keep accurate records of cash flow projections. Set a regular time to pay yourself, such as weekly or monthly, and stick to it. With consistent payments, you’ll be able to better plan for taxes or other large expenses.
Paying yourself fairly from your business
Paying yourself fairly and consistently is essential to running a successful business. Whether you’re a sole proprietor or have an LLC, S-corporation, or other business structure, there are legal and financial considerations to make when figuring out how best to pay yourself from your business.
By understanding your options and avoiding common mistakes, you can ensure that you’re taking home a fair and sustainable salary for the work you do.
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