You’ve just launched your small business or startup, and you’ve reached the point where you’re earning money. So, can you just take funds from your business account and move them to your personal bank account?
As the owner of your business, how exactly do you pay yourself?
The first thing you need to know is that there are two main ways you can pay yourself: by taking an owner’s draw or paying yourself a salary.
As for which one to use, the IRS offers some insight into which payment method is appropriate for each business structure. However, there are other factors to consider, such as how you’ll be taxed.
Keep reading to learn more about the differences between a salary and an owner’s draw, and to figure out which method is best for you and your business.
Salary vs. Owner’s Draw
First, let’s take a look at the difference between a salary and an owner’s draw.
When you pay yourself a salary, you decide on a set wage for yourself and pay yourself a fixed amount every time you run payroll.
An owner’s draw, also known as a draw, is when the business owner takes money out of the business for personal use. Owner’s draws can be scheduled at regular intervals or taken only when needed.
Salary vs. Owner’s Draw – Taxes
One of the main differences between paying yourself a salary and taking an owner’s draw is the tax implications.
For example, does the IRS see you as a full-time employee or self-employed?
An owner's draw works a little differently. Taxes are not automatically withheld when you take an owner’s draw. If you pay yourself using an owner’s draw, you’re considered self-employed, and you need to keep track of your withdrawals and make quarterly tax payments.
Deciding whether or not to classify yourself as an employee or self-employed depends on your business structure too.
Salary vs. Owner’s Draw – Eligible Entities
Your business structure helps you determine how you should pay yourself. The IRS sets rules for which payment methods can be used for each business entity.
Types of businesses that can pay owners salaries:
- Limited liability company (LLC)
- S corporation
- C corporation
Types of business where you can take an owner’s draw:
- Sole proprietorship (required)
- Partnership (required)
- LLC (required for single-member LLCs)
Multi-member LLCs have more flexibility. By default, they’re classified as a partnership, so they must use an owner’s draw. However, if you have a multi-member LLC, you can elect to be taxed as an S corp, which means you would pay yourself a salary.
Paying Yourself with an Owner’s Draw
As we mentioned above, there are three business types that allow you to pay yourself primarily through an owner’s draw, and those are the sole proprietorship, partnership, and some LLCs.
Let’s take a closer look at the accounting and tax implications of taking an owner’s draw from each of these structures.
A sole proprietorship is an unincorporated business structure that has a single business owner. It’s relatively easy to set up and is common among self-employed contractors and consultants.
When you establish a sole proprietorship, you do not create a separate legal entity. As the sole proprietor, you’re responsible for all of your business’s debts, but you also retain all of the profits.
A sole proprietorship must use an owner’s draw.
In most cases, when you draw money from the business, it’s usually moved to an equity account known as the owner’s draw account. Otherwise, you can draw money from the business account (or even the cash register) and move it to your personal account.
With this business structure, it’s completely up to you how much money you take from the business and how often you draw.
Keep in mind, though, the IRS uses the entire business’s profits to determine your personal income, which classifies as self-employment income and is subject to self-employment taxes.
When it comes time to pay taxes, you’ll pay income taxes on your business’s profits, not the amount you drew from the company.
For example, let’s say your net business profit was $50,000, but you only withdrew $35,000 in owner’s draws. The net income on your personal tax return would be $50,000, and it’s treated as self-employment income and subject to the 15.3% FICA tax, plus personal income tax.
However, as a small business owner, you can take a deduction on the other half of the FICA tax.
The IRS treats partnerships the same way as a sole proprietorship. Partners cannot legally pay themselves a W-2 salary; instead, if you have a multi-member LLC, they must use an owner’s draw when taking money from the business.
Each partner’s taxable income corresponds to the percentage of the profits they own according to the partnership agreement.
For example, let’s say you and your partner split the profits 50/50. Each partner receives 50 percent of the profits as self-employment income and must pay taxes accordingly.
Limited Liability Company (LLC)
If you have a single-member LLC, the IRS treats your business as a disregarded entity by default, which means it taxes your business the same way as a sole proprietorship. If you have a multi-member LLC, your business is treated as a partnership by default. Remember: Partnerships are similar to sole proprietorships in that owners cannot pay themselves a W-2 salary. In a partnership, you and your partner decide how to split the profits, and then your percentage of the profits is taxed as personal income.
So, by default, LLC owners must use the owner’s draw to pay themselves, and they are considered self-employed.
However, LLC owners can opt to file Form 8832, which informs the IRS to tax the business as an S corp. If you opt to have your business taxed as an S corp, then you’re considered an employee, and you must pay yourself a salary if you are active in your business.
You can draw money from the business on top of your owner’s salary, but this is referred to as a shareholder distribution in an S corporation.
How an Owner’s Draw Affects Owner’s Equity
One of the frequently overlooked business accounts is the owner’s equity account. Owner’s equity is a line on your balance sheet representing the owner’s claim to business assets.
If you’re considering selling your business in the future, you should keep track of your owner’s equity. This account represents the amount of money you keep after selling your business and paying off the business debts.
In an LLC or a corporation, owner’s equity is often referred to as shareholder equity.
It’s calculated as follows:
Asset – Liabilities = Owner’s Equity/Shareholder Equity
Assets include money invested in the business and the business’s profits. Liabilities refer to any debt owed by the business and money taken out of the business, such as an owner’s draw.
If an owner takes a draw from the business account, it increases the business’s liabilities and decreases the owner’s equity.
Paying Yourself in an S Corp
The IRS requires that all S corp owners, also known as shareholders, who are actively involved in running the business receive a W-2 salary.
As the business owner, you are still entitled to draw money from the business in the form of a shareholder distribution. However, distributions cannot be used in place of a reasonable salary.
Owner Employee vs. Owner Nonemployee
As an S corp owner, you only need to pay yourself as an employee if you are actively involved in running the business.
If you’re an employee of your business, you’ll receive a fixed W-2 salary and have your income tax, Medicare tax, and Social Security automatically withheld.
Owner salaries and half of the FICA tax paid on them are tax deductible, which means they reduce the taxable income of the business.
Some owners only make minor contributions to the activities of the business. If you’re not actively involved in the day-to-day work of your business, you may qualify as a nonemployee, which means you do not receive a salary.
As a nonemployee owner, you can still take an owner’s draw. However, you’ll use Form 1099-NEC to file taxes on nonemployee compensation.
Calculating Your Salary
When you launch a small business or startup, you may not have enough revenue to pay yourself for the first year or two.
However, once your business is out of debt and has a steady revenue stream, you need to allocate money for your salary.
But how much should you pay yourself?
The IRS instructs S corp owners to give themselves reasonable compensation to avoid any issues with the IRS (i.e. giving yourself a lower salary so you can pay less taxes could put you in hot water).
Reasonable compensation means your salary should be consistent with what you would pay another employee with the same responsibilities. You also want to make sure you pay yourself enough to cover your personal expenses.
For example, if you’re the CEO, you shouldn’t be paying yourself the same salary as an executive assistant or office manager—this might alert the IRS to investigate your pay structure.
You can use several factors when determining a reasonable salary for your position, such as your level of experience and your responsibilities. You should also research salaries for comparable positions to ensure that you’re within industry standards.
Before you calculate your salary, you should take care of some bookkeeping basics. Consult your balance sheet and figure out how much of your revenue should be put aside for business taxes. When doing so, it’s best to work with a certified public accountant (CPA) or tax advisor who can provide guidance.
Salary vs. Shareholder Distributions
Unlike a C corp, S corps don’t usually make general dividend distributions. Instead, S corp owners can draw money from the business by using shareholder distributions.
A shareholder distribution is a payment from the S corp’s earnings taxed at the shareholder level. In other words, shareholder distributions are not recorded as personal income or subject to Social Security or Medicare taxes.
Shareholder distributions are not meant to replace a reasonable salary as required by the IRS.
Taxing Remaining Profit in an S Corp
In an S corp, the owner’s salary is considered a business expense, just like paying any other employee. Any net profit that’s not used to pay owner salaries or taken out in a draw is taxed at the corporate tax rate, which is usually lower than the personal income tax rate.
This is different from a sole proprietorship, where all net profit is reported and taxed as personal income on the owner’s income tax return.
Owner’s Draw and Calculating Payroll for PPP Loans
When the Coronavirus pandemic hit, the government launched the Paycheck Protection Program (PPP) to help small businesses pay their staff. If the program opens back up again, you should know how your owner’s draws or salary affects your PPP application.
For the purposes of the PPP program, owner’s draws are not included as payroll costs. Instead, your payroll costs include only the earnings you are taxed on. Since owner’s draws are not taxed, they are not considered payroll and not covered by the PPP loan program.
Sole proprietorships, partnerships, and LLCs not taxed as an S corporation should use the net income of the business as their payroll amount. Owners of an S corp will use their regular salary, excluding shareholder distributions, to calculate payroll.
Setting Up Payments in an S Corp
Generally, owners of an S corp qualify as employees of the business and must receive a salary.
If you’re an owner who’s actively involved in managing your S corp, you’re considered an employee of the company and you’ll pay yourself a W-2 salary. You can still draw from the business account and receive shareholder distributions, but neither of these should replace an actual salary.
But what happens if you’re not working on the day-to-day operations of your business? For example, you may hire someone to do that for you. In that case, you may qualify as a nonemployee owner. Nonemployee owners can still take draws and receive shareholder distributions.
Time to Pay Yourself
Now that you know how different business structures work when it comes to paying owners, you can decide which one is right for you. If you’re the owner of an S corp, and actively engaged in business operations, you’ll need to pay yourself a salary—and not an owner’s draw. You can, however, take shareholder distributions from your business in addition to your salary. So, now all that's left to do? Get out there and make that dough!