If you run a business and you’re not sure how to pay yourself, you’re not alone. Even with guidelines from the IRS, determining what makes sense for you can seem complicated. Plus, more than 70% of business owners work more than 40 hours a week, so it’s not unusual for personal finances take a back seat to priorities like sales, marketing, production, administration, technology — and everything else you need to get done.
Fortunately, figuring out whether to pay yourself by owner’s draw or salary (while staying in the good graces of the tax man) isn’t too hard once you understand the basics.
There’s also some upside: Making the correct choice for you and your business will help you save on taxes, maximize cash flow, maintain tax compliance, and even avoid personal liability for your business’s debts.
Ready, let’s take a further look…
Salary and owners’ draw simplified
You probably already know there are two options for paying yourself. Here’s what they mean:
Salary: Paying yourself a salary means you pay yourself a fixed amount each pay period. When you choose to go with a salary, taxes will be withheld from your paychecks and your company will send your tax payments to the IRS on your behalf, just like any other employee. Taking a salary makes it easy to anticipate the company’s cash needs and it helps you pay your personal taxes in a timely way.
The IRS even requires owners of S-corps and C-corps who are involved with the running of the business to take salaries, which must include “reasonable” levels of compensation. We will discuss different entity types in more detail below.
Owner’s Draw: Also referred to as a “draw,” an owner’s draw is when you voluntarily choose to take money out of your business. After all, if your company makes $100,000 in profit, then that profit is all yours, right? Assuming there are no co-owners, you’re free to write yourself a check or even take money out of the cash register for your personal use. In fact, if you’re a sole proprietor, a draw is your only option to paying yourself.
Draws are not limited to cash withdrawals, either. Going to the ATM or writing yourself a check are technically cash withdrawals, but you can take non-cash withdrawals too. For example, say your company gets a bulk discount when it buys computers. If the company pays for a computer at the discounted price and gives it to your family, that would also be a form of a draw.
Draws can be a fixed amount paid at regular times or can be taken as needed. As the business owner, you have the discretion on when to take draws. But, because no taxes are withheld or remitted to the IRS, you’ll need to keep tabs on where that cash flow is going and make quarterly payments or settle up at the end of the year.
If you’re a sole proprietor, it’s all coming from one big pot, but if you’re an LLC, intermingling your business and personal finances can mean losing your limited liability status.
Below is a chart with the difference between the salary and owner’s draw.
Salary vs. Owner’s Draw at a Glance
|What is it?||Fixed payments on a regular schedule||Discretionary payments that are made whenever you choose. Can be non-cash.|
|Pros||Taxes withheld so you don’t have to worry about budgeting for a lump sum payment at the end of the year. Easy to budget||No taxes withheld Doesn’t require regular cash flow: You can draw when you have the cash on hand.|
|Cons||Requires regular cash flow||Not easy to budget You need to plan for year-end tax liabilities|
|Eligible entity types||LLC |
S-Corp (active owners must take a salary)
C-Corp (active owners must take a salary)
|Sole proprietor |
S-Corp (you can take draws in addition to a salary)
Be careful with loans!
Steer clear of classifying any money you draw as a loan. Loans to owners must have terms like those required in traditional lending arrangements. That means there must be a signed promissory note, with stated reasonable interest rate, and a repayment schedule. There must also be consequences for non-payment. Otherwise, you risk the IRS reclassifying these “loans” to dividends or salary.
Plan ahead for taxes
The U.S. income tax system is a pay-as-you-go system and you are expected to pay taxes as you earn your revenue. If you’re using the draw method, you’ll need to set aside enough money to pay your tax bill. This may require you to make estimated quarterly payments to the IRS: If you owe more than $1,000 on April 15, you’ll be penalized.
If you have any questions about how to pay yourself, talking to a tax pro is always a good idea. No two businesses are the same — nor are the needs of business owners — so someone who understands your situation better will be able to help you make the right decision between paying yourself a salary or taking an owner’s draw.