.png)
Salary method vs. draw method
There are two main ways to pay yourself: The draw method and the salary method.
With the draw method, you can draw money from your business earning earnings as you see fit. Rather than having a regular, recurring income, this allows you to have greater flexibility and adjust how much money you get depending on how business is going.
With the salary method, you’re regularly paid a set salary just like any other employee.
The best method for you depends on the structure of your business and how involved you are in running the company.
Option 1: The draw method
Also known as the owner’s draw, the draw method is when the sole proprietor or partner in a partnership takes company money for personal use.
Pros
The benefit of the draw method is that it gives you more flexibility with your wages, allowing you to adjust your compensation based on the performance of your business.
Cons
An owner’s draw requires more personal tax planning, including quarterly tax estimates and self-employment taxes. The draw itself does not have any effect on tax, but draws are a distribution of income that will be allocated to the business owner and taxed.
How much can you draw for yourself?
You can draw as much as you want and as many times as you want if you’re using the draw method (as long as there’s money in the account to draw from).
Just keep in mind that draws can limit the amount of cash you have available for growing your business and paying the bills.
What the draw method means for income taxes
Taxes around the draw method vary a bit based on your type of business.
Taxes on owner’s draw as a sole proprietor
As the sole proprietor, you’re entitled to as much of your company’s money as you want. You don’t have to answer to stockholders or shareholders, leaving you free to take payments as you see fit.
Draws are not personal income, however, which means they’re not taxed as such. Draws are a distribution of cash that will be allocated to the business owner. The business owner is taxed on the profit earned in their business, not the amount of cash taken as a draw.
Taxes on owner’s draw in a partnership
The IRS views partnerships similar to sole proprietorships. Profit generated through partnerships is treated as personal income. But instead of one person claiming all the revenue for themselves, each partner includes their share of income (or loss, if business hasn’t been good) on their personal tax return. In other words, earnings are divided and taxed accordingly.
Taxes on owner’s draw in an LLC
The rules governing Limited Liability Companies vary depending on the state, so be sure to check your state laws before moving forward. There is no tax on a draw for an LLC or any passthrough entity.
Further reading: LLC Owners: A Guide to Paying Yourself
Option 2: The salary method
Business owners who pay themselves a salary receive a fixed amount of money on a regular basis.
Pros
If you hate admin, you’ll like the salary method. State and federal personal income taxes are automatically deducted from your paycheck. On the personal side, earning a set salary also shows a steady source of income (which will come in handy when applying for a mortgage or anything else credit-related).
On the business side, paying yourself a straight salary makes it easier to keep track of your business capital. Instead of taking from the business account every time you need some money, you know exactly how much company money is being paid to you every month. This makes it easier to track expenses and manage cash flow.
Cons
The downside of the salary method is that you have to determine reasonable compensation that makes you happy, keeps your company operational, and isn’t double-taxed. If your compensation falls outside the “reasonable” range, it could raise flags with the IRS.
How easy is it to change your salary?
The good news about a set salary is that it’s not static and binding. You can easily change or adjust it over time so that it evolves alongside your business.
But how do you know how much to increase (or decrease) your salary?
Once you’ve reached a break-even point in the business, it’s a good idea to correlate any salary increases (or bonuses) to the performance of the business.
There are a couple of ways you can approach this:
Option 1: Lump-sum year end bonus
Take a look back at the past year and give yourself a bonus that correlates to company growth after break-even. If your company grows net profits by 15% over the course of the year, then you’d take a 15% lump-sum bonus on top of your base salary at the end of the year.
Option 2: Quarterly bonuses
Parcel out bonuses to yourself each quarter that correlates to company growth after break-even during that period.
Option 3: Adjust annual salary based on annual growth
If you’re not interested in the bonus route, you can always adjust your salary each year based on how your company is performing.
So if your company grew by 50% in the past year and your current salary is $70,000, you’d multiply your salary by 150% and come up with your new salary, which is $105,000 (not bad!).
How do you determine reasonable compensation?
The IRS’ golden rule on setting your compensation is that it has to be “reasonable”. According to the IRS, reasonable compensation is defined as:
“An amount that would ordinarily be paid for like services by like organizations in like circumstances.”
Translation: find other companies like yours and choose a salary similar to their founder/owner.
Here are a few other elements to look at to help you choose a salary that’s comfortable for you and acceptable in the eyes of the IRS:
- Your qualifications and relevant training
- How many years of experience you have
- The industry and scope of your work
- The size of your business
- The salary of people in similar positions
- Location and cost of living
If you score high marks on all those categories, feel free to give yourself a slightly higher than normal compensation package. You’ve earned it.
How to pay yourself (by entity type)
So now that you know a bit about the different options available, let’s talk about how to factor in your type of business to this equation.
There are five common business structures, and each one influences the way small business owners pay themselves.
Note: With both NFP and Corporations, it’s not recommended to take frequent draws. For NFP organizations, there are strict reporting rules to make sure that the organization isn’t set up to generate profit. For owners of Corporations, there are rules to limit how much you draw—it’s not your money, it’s the company’s money.
How to pay yourself in an LLC
If you own a single-member LLC, or are part of a multi-member LLC, you’ll need to use the draw method to pay yourself. LLC owners are not allowed to pay themselves a regular salary.
How a partner draw works
By definition, partnerships share in the income of a business. Usually that means each partner will evenly split the income for themselves. But it doesn’t have to be that way. You can arrange something different in a partnership agreement, such as a 70/30 split between two partners.
But whatever you agree on, you have to stick to. At year end, the partnership will file a Schedule K-1 that reports the business’s profits, losses, deductions, and credits, as well as any draws.
Owner’s draw in an S corp
Since an S corp is structured as a corporation, there is no owner’s draw, only shareholder distributions. But a shareholder distribution is not meant to replace the owner’s draw. Instead, you must take a salary as a W-2 employee.
A shareholder distribution is a non-taxable event, and if you try to replace your regular, taxed, W-2 income with non-taxable distributions, the IRS will catch you.
Owner’s draw in a C corp
C corp owners typically do not take draws. Instead, shareholders can take both a salary and a dividend distribution.
A C corp dividend is taxable to the shareholder, though, and is not a tax deduction for the C corp.
Further reading: IRS guidelines on paying yourself from a corporation
How to pay yourself from your business account
Whether you choose to draw your money or assign yourself a salary, there are a few guidelines you should follow when paying yourself from your own bank account.
- Withdraw the money from your business account and deposit it in your personal account. Keep these two separate.
- If you’re on the draw method, stick to relatively equal payments at regular intervals.
- Record your payments with payroll software (we recommend Gusto).
- Always leave enough cash for your business to operate smoothly after payments.
- Account for taxes. Income and FICA taxes have to be paid regardless of the method you choose.
Recording owner’s draw and salaries on your books
Draw method
If you do make a draw, you’ll need to record it on your books.
There are two “accounts” that are affected when you remove cash from your business: the Cash account and the Owner’s Equity account (these are both reflected on your balance sheet.) Cash is straightforward—the amount of cash in your bank is decreasing. Owner’s Equity is the total amount of money you as the business owner have invested or drawn from your business.
When you’re recording your journal entry for a draw, you would “debit” your Owner’s Equity account, and “credit” your Cash account.
If you frequently add money to your Owner’s Equity account—for instance, by investing funds from another company into your business—you may want to create an Owner’s Draw Account; it’s a sub-account of Owner’s Equity. This can make it easier to keep track of money entering and leaving Owner’s Equity
Salary method
If you’re paying yourself using the salary method, you’re not affecting Owner’s Equity. Instead, your salary is treated as a business expense.
So for your journal entry you would “debit” your Expense account and “credit” your Cash account.
Making the call: How much do you pay yourself?
Sole proprietors, partners, and owners of LLCs are free to pay themselves as they wish.
But you still need to strike a balance that lets you live comfortably and doesn’t hurt your business. It’s always a good idea to talk to an accountant beforehand. They can help you calculate expenses and look at projected income, so that you can earn a good living and watch your business grow.
If you run a corporation or NFP, you have to assign yourself a reasonable salary. The IRS determines what is and isn’t reasonable salaries for CEOs and non-profit founders in order to prevent certain tax benefits from being exploited. As we mentioned earlier, you can determine what a reasonable wage is by comparing your earnings to CEOs in similar positions.
Make sure to keep a paper trail documenting your company’s performance and expenses so you can justify your wages if need be. Not sure how to do that? Check out our guide, Bookkeeping Basics for Entrepreneurs.
.png)
