By now you know that owning a business doesn’t mean you’re sitting in your office with cash raining down on you.
Being a business owner means that you’re probably working nonstop to keep up with daily operations. Running your business is a full-time job!
Are you being paid for your hard work? The IRS requires that Americans earn reasonable compensation, whether they are employees or employers.
Business owners can receive either a salary or a draw from their businesses depending on the structure, expenses, profits, and reasonable compensation guidelines for their geographic area.
> A salary is a set amount that is paid to an employee or business owner on a regular basis with a paycheck that includes payroll tax withholdings.
> A draw is a portion of the profits distributed to the owners without payroll tax withholdings.
C Corporations must pay owners a salary if they are actively working for the corporation, just like an employee. If they were not actively working for the corporation, then they would receive dividends as a shareholder instead.
S Corporation owners can take a salary plus they can also take draws. Like a C Corporation, the salary would be paid only if the owner worked for the business and would be taxed like normal employee compensation. If the owner didn’t work for the business, though, they’d receive shareholder dividends instead of a salary.
Some S Corporation owners sneakily (and riskily) take draws instead of salaries to avoid paying payroll taxes. This has caused increased IRS scrutiny of S Corporations over the past several years. Incorrectly reported payroll taxes can result in expensive IRS penalties and interest, one of the largest financial risks to business owners. The cost of getting caught is far higher than the payroll tax savings you might have saved.
LLCs, partnerships and sole proprietors, on the other hand, can take draws whenever they’d like, for as much as they want, and without payroll tax withholdings. The IRS will impose a self-employment tax, though, and estimated taxes on the income because partnerships, sole proprietors, and LLCs are taxed at the personal level.
The moral of this story is to consider the eventual tax bill when taking a draw. A rudimentary system such as stashing cash aside in an envelope to pay the inevitable tax bill, writing regular checks to the IRS, or making quarterly estimated tax payments would do the trick.
Best practices and better organization would dictate that proprietors and partners pay themselves some kind of regular salary in addition to their draws. By scheduling regular payments from the business account, there’s a clearer picture of what it costs to run the company.
That said, how much could business owners pay themselves? Here are some factors to consider:
Profit – Obviously, if your business is barely making ends meet then you should lower your personal income. But if your business cash flow is healthy, then you can increase your pay and base your salary on the business’s income. Most owners limit their pay to no more than 50% of the profits. Your business should keep enough profits to continue operating efficiently and still be able to grow.
Expenses – When deciding how much to pay yourself, don’t forget to consider other costs. Businesses have many expenses, from insurance and inventory to utilities and employee wages. If business expenses exceed income, then you would need to take a pay cut, perhaps temporarily. You are responsible for paying your employees before you pay yourself and ensuring that all expenses are accounted for.
Reasonable Compensation – Government guidelines suggest that businesses pay salaries comparable to what other businesses pay for the same work under similar circumstances. The IRS may investigate a business if they think owners are being paid excessively.
It’s a huge milestone when your business evolves from a startup to a profitable venture! It’s time to start paying yourself for your efforts.
Watch the short video tutorial below from the folks at QuickBooks on how to record an owner’s draw:
Sherman Oaks Accounting & Bookkeeping powered by One Source Services, Inc. has certified QuickBooks Pro Advisor Accountants standing by to advise business owners on issues including salaries vs. draws.