How to Pay Yourself as a Business Owner

Here’s the dilemma for business owners: the business is growing, and you’d like to invest some of the profits back into it.

But you’ve been working long hours and need to earn money.

Where’s the balance? As a business owner, how should you pay yourself? And how much?

How do Small Business Owners Pay Themselves?

Small business owners have several options for paying themselves. These options are influenced by the structure of the business and its earnings. Different business structures also offer various tax advantages.

For example, if you’re a sole proprietor of a business, you can take an owner’s draw. The draw is money you pull from equity in the business – money that you’ve previously invested into the business.

If your business structure is a partnership the partners can draw a salary or receive distributions. Or each can do an owners draw.

If your business is a corporation, you can receive dividends as corporate shareholders.

Each method of payment includes its own specifics of how to pay taxes on the money.

How to Decide How to Pay Yourself as a Business Owner

Research the pros and cons, as well as tax implications, of each choice of specific business structure.

Business Entity

If your business is a sole proprietorship, such as when you pay yourself as a freelancer, you can deduct expenses. You can also deduct the amount of your draw, or draws – the money you pay yourself back from your investment into the company. This money is not taxed when you do the draw, and it can be deducted as an expense.

If you are a single-member LLC (limited liability company), you also have the option to take a draw. The benefit of this structure is that your personal assets, including your home and vehicle, are protected.

If you’re a partnership, which is two or more owners, you are personally liable for business debts. Income in the form of draws or salaries can be tied to the percentage of money each partner has invested. That would be spelled out in the partnership agreement. For example, if there are 3 partners and one put in 50%, and the other two each put in 25%, on a $10000 draw one partner gets $5000 and each of the other gets $2500.

If you’re a corporation (c corporation), the corporation will be taxed as a separate entity. The owner and shareholders may get dividends.

Taxation

Income generated from a sole proprietorship, a single-member LLC, or a multi-member LLC is generally reported on Schedule C as Profit or Loss from Business. You will be taxed on this income on your personal tax returns based on your tax bracket. If you’re wondering how to pay yourself as a business owner, it’s important to understand these tax implications.

You’ll also pay self-employment tax as part of your tax bill, which is a tax to fund Social Security and Medicare.

A corporation is taxed as its own entity. You’ll be taxed on dividend income on an IRS 1040 form.

Owners Equity

Owners equity is how much has been invested into the company. It can include the startup monies that were used to purchase real estate and equipment.

In a business plan, owners make a projection for how they hope the business will grow. Many owners have a plan that may include putting a certain percentage of profit back into the business.

However, unprecedented challenges such as the pandemic can make those projections unrealistic.

How much should you pay yourself? It’s essential to draw a living wage from your own business, as you are the one responsible for its sustainability. After all, who else will ensure the business thrives? There may be occasions when business owners need to withdraw equity to cover personal expenses.

Small Business Salary

A salary can be based on revenue or can be a set amount in a guaranteed payment. That can be easily tracked through a separate business account. Paying yourself can be as simple as transferring money from the business to the personal bank account. But you have to be careful because you don’t want to be using a business account for personal use.

A reasonable salary for a business owner can vary depending on the revenue generated. It may be calculated as a percentage of the total revenue. Additionally, you can choose to pay the salary on a regular schedule, such as bi-weekly or monthly. For more information on how to pay yourself as a business owner, consider these options.

What are the Pros of Paying Myself with a Salary?

1. You’ll have a regular payment to count on.
2. You can elect to be paid a percentage of profits, which will provide an incentive to keep the business performance growing.
3. If you are actively involved in managing the company and are also its owner, the IRS requires you to pay yourself a salary.

What are the Cons of Paying Myself with a Salary?

1. If you have a standard salary regardless of profit, you run the risk of making the business unstable as it grows if profits aren’t as great as projected.
2. You’ll be taxed on it as income when you pay income taxes.

Owner’s Draw

What are the Pros of Paying Myself with an Owner’s Draw?

1. The amount of a draw is deducted from profits as an expense, which will reduce the overall company’s profits amount (lowering taxes).
2. You’ll be getting back the money you put into the company.
3. You are only taking back what was put into the company, and additional profits can be reinvested.

What are the Cons of Paying Myself with an Owner’s Draw?

1. Pulling out money using the owner’s draw reduces the business capital.
2. The rules on draws from llcs vary greatly from state to state. You may need tax advice before your set up draws from an llc.

What Mistakes Should I Avoid When Paying Myself as a Small Business Owner?

1. You must have a separate business bank account.
2. For personal income tax, you should pay estimated taxes on a quarterly basis.
3. It would be best if you decided on a payment method before choosing the best setup for a business entity.
4. It would be best if you had a payment schedule based on what your state Department of Labor requires. Although you’re paying yourself, you’ll have to abide by standards your state sets for payments, either weekly, biweekly or monthly.
5. You need a rainy day amount to keep on hand for unexpected operational expenses, based on your financial statements and any guaranteed payments.
6. Set aside money to pay and file taxes at the end of the year.

How much should you pay yourself as a business owner?

To establish reasonable compensation, many business owners consider the following factors as a foundation for their calculations: basic expenses, the business’s performance and profit, the growth plan, and personal financial needs.

What is the best way to pay yourself as a business owner of an LLC?

Sole proprietors can use an owner’s equity formula: The amount the only owner invested, plus profits, less outstanding money owed, and draw.

What Types of Tax Will I Need to Pay for a Small Business?

• Personal tax return based on business profits.
• Self-employment taxes
• Payroll tax
• Business taxes – Federal income tax, social security and medicare taxes, Federal unemployment tax.
• Excise tax – If you manufacture and sell certain products.

Image: Depositphotos

This article, "How to Pay Yourself as a Business Owner" was first published on Small Business Trends