According to studies, a staggering 70% of small business owners work over 40 hours a week. This is because they are often juggling multiple roles to keep their business moving along. With the amount of time that operating a business takes up, it’s important to understand the best way to compensate yourself through your business. If you are a small or medium-sized business owner, you may be wondering what is the best option to pay yourself. You may be contemplating the difference between an owner’s draw and a salary. Well, you’re not alone in pondering this decision.
This article gets into the nitty-gritty of “owners draw versus salary,” guiding you through each option, their benefits, tax implications, and how your business type influences your choice. By the end, you should have the knowledge to make an informed decision about how to pay yourself through your business. Let’s get started.
What is an owner’s draw versus a salary?
Knowing the main differences between an owner’s draw and a salary is crucial for any business owner making decisions about their compensation. Let’s break down these concepts for a better understanding.
An owner’s draw is a financial transaction in the amount you, as the business owner, can withdraw from your company’s earnings or the capital you’ve personally invested. This approach provides flexibility and adaptability. You have the freedom to decide how much to draw and when to do it, allowing you to respond to both your personal financial needs and the financial needs of your business.
Imagine your business has a particularly profitable month. With an owner’s draw, you have the freedom to reward yourself for this success, potentially drawing more than in other months that are not as profitable. This method is especially appealing to businesses that experience seasonal fluctuations or irregular cash flows, as it allows the owner to align their withdrawals with the business’s performance.
However, this flexibility comes with responsibility. As an owner taking draws, you need to be mindful of your business’s financial health and ensure that your withdrawals don’t adversely affect its operational capacity or growth potential.
What are the advantages of an owner’s draw?
The owner’s draw comes with several appealing advantages, particularly for businesses like sole proprietorships, partnerships, and LLCs:
- Tax Advantages: Draws are not subject to payroll taxes, potentially lowering your overall tax liability in the short term.
- Flexibility: The amount and timing of a draw are at your discretion, offering significant flexibility based on business performance.
- Ownership Stability: Draws do not affect your equity in the business, maintaining your full ownership stake regardless of the withdrawal amount.
On the other side, an owner could take a salary. This method involves paying yourself a predetermined, consistent amount at regular payroll intervals – just like a traditional W-2 employee. Opting for a salary brings a sense of stability and predictability, both in personal financial planning and business budgeting.
What are the advantages of an owner’s salary?
Drawing a regular salary as a business owner has its own set of benefits:
- Consistency: Salaries provide a stable, predictable income, easing personal financial planning.
- Tax Management: Payroll taxes are automatically deducted from salaries, simplifying tax time considerations.
- Credibility: Regular salaries can enhance credibility with lenders and investors, potentially aiding in business growth and financing.
Does the type of business impact how owners can pay themselves?
The structure of your business is not just a legal formality; it’s a determining factor in how you can and should compensate yourself. Let’s discuss how different business structures impact your pay options.
Sole Proprietorships and Partnerships
With sole proprietorships and partnerships, the concept of an owner’s draw is appealing. These business types are characterized by their simplicity and direct connection between the business’s finances and the owner’s personal finances. Here, owners are essentially the business, and the profits made are directly attributed to them. This structure makes the owner’s draw a natural choice, offering the simplicity and flexibility these business types often require.
Corporations and S-Corporations
When we think about corporations, especially S-corporations, the situation changes. These structures often require that owners who work in the business pay themselves a salary. This requirement is not arbitrary; it’s rooted in ensuring that payroll taxes are properly accounted for and that the compensation aligns with industry standards.
For S-corporation owners, the term “reasonable compensation” is key. The IRS scrutinizes these salaries to ensure they reflect the value of the services the owner provides to the corporation. This means that as an S-corp owner, you need a balance. Your salary should mirror what someone in a similar position, with similar responsibilities in a similar industry, would earn. This not only ensures compliance with tax laws but also maintains fairness in compensation.
How does this impact taxes?
The way you choose to pay yourself has profound tax implications. Let’s take a look.
Owner’s draws and tax planning
Opting for an owner’s draw results in a more hands-on approach to your taxes. Since these draws are not subject to automatic tax withholding, it’s your responsibility to account for and pay your income taxes. This often involves making estimated quarterly tax payments to the IRS.
For sole proprietors, partners, and LLC members, the amount drawn is considered personal income, subjected to self-employment taxes covering Social Security and Medicare. This self-employment tax rate stands at approximately 15.3%, split between Social Security and Medicare. Therefore, it’s crucial to accurately calculate and set aside funds for these obligations throughout the year.
Salaries and automatic tax handling
Salaries simplify the tax process significantly. If you’re on a salary, your business withholds income taxes, Social Security, and Medicare contributions from each paycheck. This not only streamlines tax management but also provides a level of predictability and ease in budgeting personal finances.
For owners of S-corporations, the tax scenario gets a bit more nuanced. While your salary is subject to payroll taxes, any additional profits passed through the S-corporation to you as the owner may not be subject to self-employment taxes. This can create a tax advantage, but it requires careful balancing to meet the “reasonable compensation” criteria set by the IRS.
Deciding between an owner’s draw and a salary is a choice that requires considering your business type, financial needs, and tax implications. An owner’s draw offers flexibility and potential tax advantages but requires careful tax planning and management. A salary, while less flexible, provides stability and simplifies tax payments. Ultimately, your decision should align with your business’s personal financial needs. It’s always best to consult with a financial advisor or tax professional to make the best choice for your unique situation. Feel free to contact our team for help with the payroll needs of your business.