How to pay yourself as a business owner depends mainly on the stage of growth of your business and the company structure you’re using. While affording yourself a salary may not be the first thing that comes to mind, doing so can help you stay motivated as you continue to scale. Here are a few ways business owners can start paying themselves their fair share.
1. Owner’s Draw
Using an “owner’s draw” for payment is one of the two most common “pay yourself” methods.
Who Uses the Owner’s Draw Method?
Sole proprietorships, partnerships, and Limited Liability Companies (LLCs) can pay themselves using the “Draw” method, also known as the owner’s draw. LLC owners are not allowed to pay themselves a regular salary by law and thus can only use this method along with a Schedule C for 1040 during tax time. Single-member LLC owners must file self-employment tax.
However, a multi-member LLC can use a distributive share and is required to use a Schedule K-1 (not C) for 1040. If a member of an LLC is hiring an independent contractor to handle a portion of their work, they cannot pay them a salary or an owner’s draw. LLC owners who use independent contractors frequently could use fillable 1099-NEC templates for this process.
What are the Pros vs. Cons?
One of the pros of using the draw method is that it gives entrepreneurs more flexibility with their wages, allowing them to adjust based on performance. However, unlike with salary, your taxes aren’t automatically deducted. Therefore, you need to self-report any draws and pay taxes at tax time. You may need to make quarterly tax estimates and commit to more personal tax planning.
How Much Can You Draw?
When using the draw method, entrepreneurs can draw as much as they want anytime they want, but they need to limit the amount of cash they take out. Otherwise, they won’t know how much they can or can’t use to grow their business.
2. Salary
Establishing a salary for payment is the other standard method entrepreneurs will use.
Who Uses the Salary Method?
Not-for-profit (NFP), S Corps, and C Corps can pay themselves using the salary method. S/C Corporation owners who work in the business receive a salary. The same goes for NFP owners, but they may not start paying themselves right away due to the charity aspect. If the business owner is a part of the day-to-day runnings of the business, they are considered employees.
They will typically take a salary and pay employment taxes that must be paid per paycheck. In addition, S/C corporation shareholders may take additional distributions of profit from the business. Some corporation owners may pay minimal amounts to corporate officers to limit the amount of employment taxes paid, but this amount changes based on multiple factors.
What are the Pros vs. Cons?
Business owners that hate administration will love this method as federal and state income tax is removed with every paycheck. Owners will also know what they are expected to earn each month, which helps them keep capital. At the same time, it’s challenging to determine what “reasonable compensation” is for the business. An inaccurate wage could raise flags with the IRS.
How Much Can You Draw?
The amount you can draw is based on the following factors:
- Business Size
- Industry
- Scope of Work
- Experience
- Qualifications
- Cost of Living
- Competitive Pay
CEOs are welcome to a higher paycheck due to their position, so if you exist in a lucrative industry, you’ll be paid quite well. After deciding what your payment amount will be based on the above factors, you can pay yourself a performance bonus if your business scales. These bonuses can be doled out quarterly, yearly, or through a salary adjustment.
3. Dividends
Besides salary and owner’s draw, business owners can choose to pay themselves through dividends. An owner of a corporation or an S/C corporation is declared a shareholder, and as a shareholder, they take dividends when the corporation decides to pay them. However, many growing companies may choose to put those dividends back into the business. Those who receive dividends will not pay self-employment tax and must use a 1040 IRS tax sheet.
Individual dividend taxes are often lower than regular income taxes. Therefore there is a benefit for the owner to take compensation this way. Although public corporations are often the business structure-types that payout with dividends, even closely held corporations can use this structure. Other businesses, like LLCs, must provide distributions rather than dividends.
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